Question

Define Coase Theorem. Show on a graph how efficiency can be restored in the presence of negative externalities via private negotiations under certain conditions.

Answer 1

Coase theorem describes the efficiency of an economic allocation or outcome when there are externalities. The theorem says that if trade in an externality is possible and there are sufficiently low transaction costs, bargaining will lead to a Pareto efficient outcome no matter what the nitial allocation of property. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasian bargaining.

Thus with externalities the output will be at q1 as compared to the social optimal at q2. This can be reduced through collective bargaining and bring it back to the social optimal.