Published in Insights, The New Zealand Initiative’s newsletter, 6 September 2013

Imagine the following situation: Your next-door neighbours are going to have a party. They know it will be noisy and it might last till the wee hours. They also know that you value your sleep. And they are afraid you might call the police for disturbing the peace. Not everybody likes listening to a karaoke impromptu of Elvis classics at 3am.

So what might your neighbours do to avoid potential conflict? Maybe they will see you before the party with a bottle of wine to compensate you for your forbearance. Or even better, they will just invite you to come over for the celebration.

In either case, they would have unwittingly demonstrated the validity of the Coase theorem.

The non-economists may now ask ‘The what theorem?’ But any economics student over the past half a century would have come across the name of Ronald Coase, one of the great economists of the 20th century. The Nobel laureate died on Tuesday, aged 102.

In his most famous article ‘The problem of social cost’, published in 1960, Coase gave a new answer to the problem of externalities. An externality occurs when someone’s actions cause harm or benefit to another person. A neighbour’s loud party would be such an externality. It could also be a factory polluting a river so that the fishermen downstream are losing their catch.

Before Coase, economists believed that such harmful behaviour could only be stopped by government intervention. The state might tackle the problem by regulating the polluter or taxing the pollution.

Coase showed that it is possible to deal with such externalities without the heavy hand of government. Say if the polluting factory owns the river, the fishermen might pay the factory for treating the effluent. Conversely, if the fishermen owned the river, the factory might pay them for the right to reduce their catch. Even if neither owned the river, they might still reach an agreement through negotiations that would be socially optimal.

The crucial insight Coase offered was the importance of property rights. Once they are properly defined, the market can take care of issues like pollution and other externalities. Where they are missing or difficult to enforce, it is much harder to deal with external effects.

Coase’s theorem has important implications for economic policy. Wherever externalities occur, clearly defined and enforceable property rights can reduce the need for government intervention.

The Coase theorem equally applies to radio frequencies, fishing quotas, or Internet domain names.

It may even gain you an invitation to your neighbour’s next karaoke party.