The self-curing failures of the Coasean bargaining

In a situation in which there is a non-optimal allocation of rights between two individuals, the Coase theorem predicts that the interested parties will con­tract with each other and that they will reallocate their respective rights so as to maximize their combined welfare.

The dynamic effects of alternative liability rules

Calabresi⁵³ and Stanislaw Wellisz⁵⁴ are notable among the scholars who criticized Coase’s model for disregarding the inter-industrial long-term ef­fects of the Coasean bargaining. According to these authors, Coase’s scheme does not take into account the dynamic effects of alternative liability rules among the various parties, and consequently, it ignores the long-term ef­fects of the rules on different industries. In Coase’s scenario, if the right has been assigned to the ranchers, the farmer will have to pay local ranchers until they all relinquish their right of pasture. The entire cost will, thus, burden the farming industry. Farmers will either have to bear the burden of the injury caused by the livestock or agree to pay the price demanded by the ranchers, whichever is less, assuming costless negotiation. Under this liability rule, the cost of ranching will not reflect the cost imposed on the farmers. The transfer of rights and liability from one group to another will, therefore, result in a shift in the relative wealth and costs associated with the two industries.

The criticism claims that, in the long run, every shift of wealth will lead to an inter-industrial disequilibrium. Even in the absence of transaction costs, a different assignment of rights can alter the equilibrium between different industries, with consequential effects on the cost and quantity of their relative products.

Formulated in this way, the criticism appears to be on the mark. The efficiency of the Coase theorem is demonstrated only through a static analy­sis. If dynamic adjustments are taken into consideration, the structure of the model reveals its incapacity to consider the long-run inter-industrial effects of different initial allocations. However, in 1968, Calabresi, one of the initial proponents of this criticism, reconsidered his analysis regarding the long­term effects of the Coase theorem.⁵⁵ While elaborating on the conclusions reached in two previous works,⁵⁶ he noted that, in the presence of determined conditions, the conclusions of Coase remain as true in the long run as in the short term:

Various writers - including me - accepted that conclusion for the short run, but had doubts about its validity in the long run situation. The argument was that even if transactions brought about the same short run allocation, liability rules would affect the relative wealth of the two joint cost causing activities, and in the long run this would affect the relative number of firms and hence the relative output of the activities. Further thought has convinced me that if one assumes no transaction costs... and if one assumes, as one must, rationality and no legal impediments to bargaining, Coase’s analysis must hold for the long run as well as the short run.⁵⁷

In this way, Calabresi carried on the logic of his earlier argument to reach opposite conclusions.

Calabresi’s later analysis re-established the authority of the Coase the­orem, at least on this point. It became clear that Coase had not ignored the long-term effects of his model. Perhaps not explicitly, but he had considered them to their logical extreme. Calabresi proceeds: ‘The reason is simply that (on the given assumptions) the same type of transactions which cured the short run misallocation would also occur to cure the long run ones.. This process would continue until no bargain could improve the allocation of resources’.⁵⁸

Harold Demsetz on the long-term effects

In 1972, Harold Demsetz entered into this debate, demonstrating with a more systematic analysis that the conclusions reached by Coase are not corroded by the long-term effects of a change in the assignment of property rights.⁵⁹ Demsetz’s reasoning finds its basis in the principle according to which the process of allocation of scarce resources among alternative uses is analogous to the process of constrained optimization of the single owner of two conflict­ing activities.

In order to better understand Demsetz’s reasoning, imagine a situation in which the two activities, farming and ranching, ‘belong’ to the same indi­vidual. This person has every interest in making the optimal allocational choice in the use of his/her limited resources between the two activities, and will tend to maximize the sum of his/her benefits at the net of the costs. Such a choice would lead to the optimal use of his/her resources in both the short and long terms, regardless of the equilibrium reached in the two industries or activities.

Approached in this manner, the true problem seems to remain that of perva­sive scarcity of resources, not of assignment of rights.⁶⁰ In our example, the single owner of the two activities will not be interested in establishing whether the herd is creating a nuisance to the crops or whether the crops are becoming an obstacle to the ranching activity.

These conclusions, however, do not appear to be fully shared by Donald Regan, who observes that the self-curing dynamic of Coase’s theorem is destined to remain a phenomenon foreign to the reality of the market.⁶² Everything is in theory corrected through the internal mechanism of a market with no transaction costs, even the inefficiency generated by the monopolist.⁶³ Individual consumers will be willing to pay the monopolist to increase the production of goods to the desired level. In the absence of transaction costs, the negotiations will proceed until the optimal equilibrium of a perfectly competitive market is achieved. But this solution is not without its shortcom­ings. According to Regan’s view - a view not shared by Coase - the free exchange of rights in the market produces irreversible transfers of wealth between the parties. According to this perspective, the market solution out­lined by Coase and Stigler - and to some extent endorsed by Calabresi - while resolving a problem on one side, immediately creates a problem on the other. Regan and other commentators direct their attention to this point of collateral effect.⁶⁴ An account of their reasoning and a tentative assessment of their findings follow in the next section.