In economics, the Coase theorem suggests that under certain economic conditions, private actors can effectively reach an efficient economic allocation or outcome in the presence of externalities.

But Coase theorem often fails to address the problem of transaction cost between two involved parties. Let’s consider two examples where the problem of transaction cost arises –

Example 1: There are two families living side by side. Mr. Adam’s house is adjacent to Mr. Robert’s house. One day Mr. Adam decides to plant pear trees in his garden but then he realizes that the Robert family will get extra benefit from picking up the pears which will fall on their side. Mr. Adam has three choices,

Choice 1: Either he plants few pear trees so that none of the pear falls on Robert’s garden.

Choice 2: He plants as many trees as possible and use a net worth of $15 to prevent the pears from falling to the other side that in turn will increase the marginal cost of producing pears.

Choice 3: Mr. Adam can ask Robert’s family to spend some amount (transaction Cost) so that they both enjoy the pears i.e. the application of Coase theorem.

Here, the problem arises when Mr. Adam asks more money than Mr. Robert is willing to pay. I.e. the transaction cost is more than Robert’s marginal cost. In, reality this often happens as both parties cannot reach an agreement and Mr. Adam is forced to choose between Choice 1 and Choice two. In both the cases Coase theorem fails.

Example 2: There is a farm and a grazing field next to each other. The rancher’s cows often get on the other side of the land and destroy farmer’s crop. Both the parties have an incentive to bargain and come to an agreement. Suppose they agree that the rancher will pay $100 (transaction cost) every month for damaging the farm. That is the ideal solution according to the Coase theorem. But if the rancher finds out that fencing his grazing land will prevent the cows from going to the other side and that will cost him $300 only. In the former case where there is an agreement, the transaction cost is much higher. So, the rancher will choose to build fence. Again the Coase theorem fails as the private parties couldn’t reach a better allocation.

Here, The SMC = Social Marginal Cost and SMB= Social Marginal Benefit. It shows that when the transaction cost is high, The social margianal cost curve is much higher than the social benefit curve hence decrease in the optimum social output. This is the mechanism of how Coase theorem fails when the transaction cost is high.

please see the attahced file. for the complete solution.