Coase Theorem

The Coase theorem states that when a firm’s production of a good results in pollution, the level of pollution remains the same whether property rights are given to the firm or the state. If property rights are assigned to the firm, the public (e.g. the town) pays the firm to reduce its pollution, and its willingness to pay depends on the benefits it received from a cleaner environment. If the town owns the property, the firm must pay for its right to pollute, and its contribution is determined by the amount it will benefit from polluting. In either case, the amount of pollution agreed on is where the additional benefits to the party that is paying are less than the additional costs. According to the Coase theorem, the equilibrium level of pollution is the same either way; the difference is who pays, the private entity or the public, in this case the town.

There are limitations to the Coase theorem. If there are multiple polluters, or more than one party affected by the pollution, the assignment of property rights actually can determine the level of pollution. Take, for example, a plant that expels waste into a river. If the river flows through two towns, the one that is further way incurs fewer costs associated with cleaning the water. The amount each town is willing to pay to reduce waste would be different, and therefore the allocation of property rights among the plant and the two towns could determine the outcome. Another limitation becomes clear when we consider transaction costs such as measurement and enforcement. For example, if more than one firm is polluting, determining how much pollution is coming from each firm could be costly or difficult. These costs could be more significant than property rights in determining the level of pollution.