Question 2:
The Coase Theorem states that if property rights are well defined, and no significant transaction costs exist, an efficient allocation of resources will result even with externalities (Harris, 2002). Coase argued that market failure, can be privately solved to an optimal level when the legal system intervenes, giving property rights to one of the parties involved. Essentially, the theorem is based on two underlying assumptions which are low transaction costs and the assignment of property rights. Firstly, the assignment of property rights is the right to have the exclusive use of their property, including the right to buy and sell it (Hubbard et al, 2009). Initially, polluters pollute because they believe they have the right too although the third party affected believe they have the right to less pollution. Hence without property rights, an inefficient level of equilibrium will be produced until the point in which the market intervenes assigning property rights. Another vital assumption is low transaction costs, which are the costs in time and other resources that parties incur in the process of carrying out an exchange of goods and services (Hubbard et al, 2009). As transaction costs of negotiating, binding and monitoring the agreement are very expensive when many individuals are involved, the transaction costs can exceed the gains from the transaction itself. When these two assumptions are held, an optimal solution will be reached when the monetary damage of one more unit of pollution to the third party is equal to the amount the polluter is willing to pay for it.

Figure 2

Figure 2

This diagram represents the marginal benefits and costs of reducing pollution, in which equilibrium (P0, Q0) is the point of maximum net benefit to society, where marginal cost is equal to the marginal benefits of reducing pollution of plastic bags. The net benefit