Economic activity can have some consequences, costly or beneficial, affecting other parties – externalities. The Coase theorem calls for private bargaining, which always leads to a better allocation of resources where externalities are present. However, such a theorem statement is not accurate since bargaining has limitations. In particular, the theorem is based on the assignment of property rights, which is not always possible, and therefore bargaining is not applicable too (Saez, n.d.). Moreover, the private discussion is often impossible or difficult if externalities affect many parties. Thus, the Coase theorem can be applied only in some cases – more personal and not large-scale.
Situation Consideration – Smoker-Nonsmoker
One can apply several solutions considering the situation with a smoking and non-smoking neighbor in the room. Passive smoking is a negative consumption externality, in which harm to health extends not only to the person who smokes but also to their environment (“Externality,” n.d.). If neighbors solved this problem by involving the state, it would apply price policy or restrictive regulations. In the first case, the smoker would have to pay a tax covering marginal damages – harm done to a non-smoking neighbor. In the second case, the state would set a limit on the time of smoking or the number of cigarettes. The limitations of such options are the complexity and expensive cost of monitoring compliance with obligations.
Neighbors can solve the problem privately through negotiations and bargaining. In this case, they are likely to establish rules and restrictions regarding smoking. For example, the rules would include smoking on the street or in the absence of a non-smoking neighbor. Such an option also has limitations, as it depends on the responsibility of one of the parties in fulfilling obligations. However, bargaining is the best solution for this situation among the suggested two. Both decisions are more likely to establish rules in terms of efficiency, but the second decision applies better in such a personal situation.
Externality. (n.d.). Corporate Financial institute. Web.
Saez, E. (n.d.). Externalities: Problems and solutions. Berkeley Econometric Laboratory. Web.