The Coase Mechanism and the Iteration Argument

The “iteration argument” presented in Schlicht (1996) shows that the allocation of property rights may generate inefficiencies, contrary to what the “Coase Theorem,” as commonly understood, asserts. The argument may be summarized by saying that markets (and bargaining) cease to function properly if several people are entitled and prepared to engage in the same externality-ridden activity and each of them has to be bribed individually from being the first offender. Given that the harm from pollution does not rise linearily with the amount of pollution, the sum-total of the damages produced when all of the potential offenders engage in the harmful activity may be smaller than the sum-total of the bribes which must be offered to prevent each potential offender from starting the offensive activity, even if the ensuing social damages exceed the associated private returns and an inefficient outcome is obtained. If pollution without permission by the community is not permitted, a different – and in this case efficient – outcome results. This note illustrates the argument by means of a simple example. It is an excerpt of Schlicht (1997).