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IAI Actuarial Core Principles · Business Economics · Government intervention in a market

Which of the following best illustrates the Coase theorem as applied to an externality?

The Coase theorem holds that where property rights are well defined and transaction costs are low, the affected parties can bargain to an efficient outcome whoever initially holds the rights. This is a private solution, unlike taxes, quotas or bans imposed by government.

  1. AThe government imposes a tax equal to the marginal external cost
  2. BWith well-defined property rights and low transaction costs, affected parties can bargain to an efficient outcome regardless of who initially holds the rightCorrect
  3. CA regulator sets a fixed emission limit for every firm
  4. DA public good is provided free by the state to avoid free riding
  5. Firms are banned from producing goods with any external cost

Explanation

The Coase theorem says that if property rights are clearly assigned and transaction costs are low, private bargaining can internalise the externality efficiently whichever party holds the right. Taxes, quotas, bans and state provision are government solutions, not private bargaining.

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