- Economic theorists have proposed that the problems created
by a Pareto-relevant externality may be solved by market transactions
between the involved parties. These market transactions would allow
realization of the potential gains from trade which characterize a
Pareto-relevant externality. After all potential gains from trade had
been realized, a Pareto-efficient solution would, have been achieved.
From the literature which has developed in the field, it is possible
to distill two propositions which are here called the Weak and the
Strong Coasian Hypotheses on Optimum Externality. These Hypotheses
require certain assumptions: perfect competition in the markets
for all factors and commodities; perfect information in a context of
static certainty; secure and well defined property rights for all factors
and commodities; and a well defined set of liability rules to serve
as a starting point, or status quo point, for negotiations. The Weak
Hypothesis states that "(m)arket transactions between individuals or
firms involved in an externality situation will result in achievement of
a Pareto-efficient solution, regardless of the initial liability rule."
The Strong Hypothesis includes the Weak Hypothesis and adds that
"(e)xactly the same equilibrium output of externality will be produced,
regardless of the status quo liability rule."
These Hypotheses are deductively tested, with the aid of simple
mathematical models, for several different types of externality situations
involving: producers only, consumers only and both producers
and consumers; transactions costs equal to zero, and transactions
costs greater than zero. For this deductive testing, the static perfect
competition framework used in the original papers is retained.
It is found that the Strong Hypothesis must be rejected for all
cases except that where no consumers are involved, in the externality
situation and variable transactions costs are zero. It is argued that
situations meeting these criteria are most uncommon in practice, and
so the Strong Hypothesis must be rejected for most practical situations.
The Weak Hypothesis is not rejected, provided that all of the
assumptions (including the crucial assumption of perfect competition
in all relevant markets) are met.
In situations where the Strong Hypothesis is rejected but the
Weak Hypothesis is not, the equilibrium output of externality is different,
under each different status quo liability rule. In this case, the
selection of a status quo point can greatly affect the equilibrium output
of externality, the distribution of income among involved parties and,
if the status quo rule has wide application throughout the economy, the
values of many other variables such as relative and absolute prices,
aggregate consumption, production and investment and real income.
Attention is drawn to the role of transactions costs in determining
whether a solution can be obtained through market transactions between
the involved parties. As the amount of variable transactions
costs increases, the disparity between the solutions achieved under
different status quo rules increases.
Transactions costs are also likely to be greater than zero when
some extra-market institutional framework is used to handle externality
situations. It is argued that the size.and shape of the transactions
cost curve under different institutions is an important variable
to consider in institutional choice. Some directions for empirical
research into the transactions cost curves are suggested.