The debate was triggered off by Megan McArdle's suggestion that Coasean bargain would take care of any conflict of preferences between two neighbours on enjoying loud music and silence. Kathy G reponded that a Coasean bargain is not possible in such a situation, since both transactions costs (information costs on locating the relevant rules, enforcement costs in getting police to register cases) are high and property rights ill-defined (Rules on loud music, silence etc).
The Coase Theorem states that, in a dispute concerning an externality, if transaction costs are low (or nonexistent) and property rights are well-defined, the parties can bargain their way to an Pareto efficient outcome(with no one being worse off and at least one person being better off). The Coase Theorem is value neutral, in so far as it is silent on fairness.
Kathy G illustrates this with an example, "A poor person living near a toxic waste dump may have a very strong preference indeed to see that waste dump removed. But even if transaction costs are zero and property rights are well-defined, that doesn't mean she'll prevail in a Coase bargaining scenario. If she has less money than the polluter, her preference, no matter how strong, will not be realized. All the Coase theorem says is that, after bargaining, she won't end up worse off. But if her resources are less than her opponent's, her preferences would not be satisfied."
Kathy G writes, "Libertarians tend to be fond of the Coase theorem, but that is because they often misunderstand it. They're likely to be enamored of the idea of autonomous actors in a free market bargaining their way to an efficient solution, with government staying out of the matter entirely. They especially prefer the Coase solution to the Pigouvian mechanism, in which the externality is internalized via a tax. But in the real world, a Coase solution to an externality is not necessarily going to be any more efficient than a Pigouvian one."
Though it is widely accepted that a Coasean bargain is difficult in the real world, Coasean-style transaction costs can be used as an analytical tool to understand how, and under what conditions, markets work.
I had dwelt with the possibility of Coasean bargains in urban areas in an earlier post in the context of Kaldor-Hicks test to determine whether an outcome is efficient or not.
It is commonplace to have complaints against some objectionable shop or commercial establishment located in predominantly residential areas, causing inconvenience to its neighbours. There is a simple solution to this problem. Assume Mr Welder wants to set up a welding shop in Soundfree Colony. Assume also that the Plant generates costs on the neighbours amounting to Rs A, and it would cost Mr Welder Rs B to relocate elsewhere. If Rs B > Rs A, then there is a possibility for a mutually beneficial bargain between the parties and Mr Welder continuing his business in Sound free colony. (The cost could for example be the amount required for setting up sound proofing system)
The problem, as Kathy G points out, lies in the transaction costs and definition of property rights that are necessary to strike the locally negotiated bargain. This is why libertarian solutions to neighbourhood civic problems fail, thereby necessitating intrusive Government regulation. But such regulations invariably develop a web of bureaucracy, with its attendant corruption and other distortions, that detracts from achieving its objectives. In the circumstances, the right way forward would appear to be taking adequate steps to lower transaction costs (local dispute settlement/negotiating mechanisms) and more clearly define individual and common property rights.
Update 1 (2/8/2010)
NYT reports of a windfarm in Oregon paying $5000 to buy silence of neighbors on the sounds made by wind turbines.