Law and Economics: Coasean Bargaining, Efficiency and Externalities
This domain tests whether you can state the Coase theorem precisely, distinguish the efficiency criteria, and choose the correct instrument for an externality rather than reciting slogans.
Efficiency criteria
A Pareto improvement makes at least one person better off and nobody worse off; a Pareto-efficient allocation leaves no such improvement available. A Kaldor-Hicks (potential Pareto) improvement has gains exceeding losses, so winners could compensate losers. Compensation need not actually be paid - that is what makes cost-benefit analysis operational, and also what makes it contestable. Willingness to accept typically exceeds willingness to pay, so measured value depends on the initial entitlement.
Coase and transaction costs
With zero transaction costs, fully specified entitlements and free bargaining, parties trade to the efficient allocation whatever the initial assignment of the right; the assignment affects only distribution - the invariance result. Real transaction costs (search, information, bargaining, holdout, enforcement) explain why law matters. Normative Coase: design law to lower transaction costs, for example through default rules and standardised entitlements. Normative Hobbes: where transaction costs are high, assign the entitlement directly to its highest-valuing use.
Externalities and remedy choice
A Pigouvian tax equal to marginal damage prices the harm, but requires the regulator to know the damage function; differentiated taxes achieve abatement at least cost through equimarginal abatement. Calabresi and Melamed distinguish property rules (injunction; consent required), liability rules (damages; consent not required), and inalienability. Property rules suit low transaction costs and high subjective value; liability rules suit high transaction costs with administrable valuation.
Worked example
A plant's abatement costs 60; the downstream fishery suffers 100 in damage, so abatement is efficient with a net gain of 40. If the plant holds the right to pollute and bargaining costs are 10, the fishery pays between 60 and 100 and pollution stops. If bargaining costs are 50, the gain of 40 is absorbed and pollution continues despite inefficiency. With high transaction costs a liability rule awarding 100, or a tax of 100, restores the efficient outcome; with low transaction costs, either initial entitlement reaches the same physical result.
Traps
The theorem does not say law is irrelevant - it says law does not affect efficiency when transaction costs are zero. Do not treat Kaldor-Hicks as requiring actual compensation. Do not ignore wealth and endowment effects in valuation. Do not assume a tax raises revenue and abatement simultaneously without checking marginal conditions.