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Misinterpreting the Coase Theorem

The Coase theorem is often interpreted as demonstrating why private negotiations between polluters and victims can yield efficient levels of pollution without government interference. It is considered by many to provide the theoretical underpinnings for "free-market" solutions to environmental problems. This article explains why misinterpreting Coasian negotiations as a market driven process leads to erroneous conclusions. More importantly, this article demonstrates why negotiations between polluters and victims would fail to yield efficient outcomes even if property rights were well-defined, even if there were only a single victim, even if negotiations entailed no transaction costs, and even if negotiators behaved rationally and reached a successful agreement. Unlike other critiques of the Coase theorem that focus on irrational behavior and transaction costs, our critique identifies perverse incentives that arise even under conditions most favorable to the theorem. By accepting, rather than challenging, the premises of the theorem, our analysis provides an "internal" critique that strengthens well-known "external" criticisms.