Introduction

Beginning with the observation of Ronald Coase, it has long been held that private bargaining can provide an antidote to the inefficiencies caused by externalities. Coase (1960) argued that

1. A pair of agents, by striking a mutually advantageous agreement, would obtain an efficient economic solution to the externality, and

2. A change in the assignment of property rights or in the liability rule would not affect the attainment of efficient agreements.

The Coase “theorem” relies on a number of assumptions, some explicit, some implicit, among which are that: agents have perfect knowledge of the economic setting including each other's utility function; in the absence of transaction costs, the agents will strike mutually beneficial agreements; and there exists a costless mechanism (a court system) for enforcing such agreements.

As many observers have pointed out, the presumptions that the bargainers have perfect knowledge of, and pursue, mutually beneficial agreements – assumptions borrowed from the theory of cooperative games – are crucial for the Coase results. The usual argument is that rational bargainers would (should) never settle on a given set of agreement terms if instead they could agree on alternative terms that were preferred by both sides. The conclusion, according to this argument, is that any final agreement must be Pareto-optimal.

Although this argument seems compelling, it leaves a number of questions unanswered.