The Coase Theorem and Real Markets: An Empirical
Analysis of Negotiations between Waterworks and
Farmers in Denmark
By
Jens Abildtrup1, Frank Jensen2 and Alex Dubgaard3
Abstract: The Coase theorem states that parties involved in externality problems will negotiate
until a Pareto-optimal level of the externality is reached provided that property rights are well
defined and allocated. This result holds regardless of the initial allocation of property rights.
However, the Coase theorem depends on a number of assumptions. Among these assumptions is
perfect information about each other´s payoff function, maximizing behavior and zero transaction
costs. Experimental studies have been conducted to consider the effect of relaxing one or two of
the assumptions. These studies show that the theorem may still holds when the assumptions are
relaxed. However, an important question is if this conclusion also holds for real market
transactions. That is the question examined in this paper. We consider results of Danish
waterworks’ attempts to establish voluntary cultivation agreements with Danish farmers. A survey
of these negotiations show that the Coase theorem breaks down in the presence of imperfect
information, non-maximizing behavior and transaction costs. Thus, contrary to experimental
results the Coase theorem did not hold in practice when the basic assumptions were violated for
the case of negotiations between Danish waterworks and farmers.
1 Corresponding author, INRA, Laboratoire d’Economie Forestière, 14 Rue Girardet, F-54000 Nancy, e-mail:
[email protected]
2
University of Copenhagen, Institute of Food and Resource Economics, Rolighedsvej 25, DK-1958 Frederiksberg, email: [email protected].
3
University of Copenhagen, Institute of Food and Resource Economics, Rolighedsvej 25, DK-1958 Frederiksberg, email: [email protected].
1. Introduction
The traditional Pigovian approach to the internalization of externalities assumes that government
intervention is required in terms of taxes on negative externalities and subsidies to the provision
of positive externalities (Pigou, 1920). In his path-breaking article “The Problem of Social Cost”
from 1960 Coase suggests that government intervention can be replaced by the market
mechanism with the parties involved bargaining over the handling of externalities. The core of the
argumentation is that if property rights are well defined and allocated and transaction costs are
zero the market will by itself reach an efficient solution to an externality problem (Coase, 1960).
This line of reasoning was labelled by Stigler (1966) as the Coase theorem.
However, the Coase theorem depends critically on a number of assumptions. Among these are
perfect information about the actors’ pay-off functions, profit or utility maximizing behavior by
involved parties and, as already indicated,zero transaction costs (see Hoffman and Spitzer, 1982).
Therefore, tests of the assumptions behind the Coase theorem are necessary to identify if the
market solution is better than a situation with public intervention. Likewise, it is relevant to test
the effects of relaxing the assumptions behind the Coase theorem .
The pollinating bees case (Cheung, 1973) and the trespassing cattle case (Ellickson, 1986) are
examples of economic studies investigating how the Coase theorem works in real life situations.
However, existing tests of the effects of relaxing the assumptions have generally been conducted
in experimental studies (see Hanley et al, 1997 for an overview). Common to the studies is that
they show that the Coase theorem is robust to changes in the assumptions. Thus, they show that
the Coase theorem still holds if, for example, the involved parties have imperfect information
about each other´s payoff function and other relevant assumptions. However, a relevant question
to ask is if this result holds outside experiments in a laboratory. In other words, the question is if
the robustness in the assumptions holds for real markets (see Déprés et al., 2008, Bougherara et
al., 2009, Cheung, 1973 and Ellickson, 1986, for related studies).
In this paper we test if the Coase theorem is robust to changes in the assumptions in real markets.
We do so by analyzing Danish waterworks attempts to set up voluntary cultivation agreements
with Danish farmers. We show, contrary to experimental studies, that negotiations break down in
the presence of asymmetric information, non-maximizing behavior and non-trivial transaction
costs. Therefore, in this case the Coase theorem is not robust to changes in the assumptions and
public intervention seems to be a better solution.
The paper is organized as follows. Section 2 gives an introduction to the Coase theorem and briefly
describes the experimental studies. In section 3 the results of our real market survey are
presented and section 3 concludes the paper.
2. The Coase theorem and experimental studies
Coase (1960) points out that a complete set of markets can be expanded beyond normal private
goods to include non-market assets as long as institutional constraints to assigning property rights
are removed and transaction costs are zero. The so-called Coase theorem states that disputing
parties will work out private agreements that are Pareto efficient, regardless of who have the
initial property right. As long as free exchange occurs, government intervention is relegated to
designing and enforcing well defined property rights.
Consider a waterworks and a farmer who disagree about the level of pollution in a groundwater
resource. The farmer produces crops and disregard leaching of nutrients and pesticides to the
groundwater. The waterworks uses the groundwater to produce drinking water. The farmer´s
emission reduces the benefit of the waterworks water production. Figure 1 illustrates the marginal
costs (MC) to the waterworks from pollution and the marginal benefit (MB) to the farmer from
pollution.
$
Figure 1: The Coase theorem
MC
C*=B*
MB
Pollution
x*
The socially optimal level of pollution, x*, is where MB equals MC. But with markets being
incomplete there is no opportunity for the parties to trade for alternative levels of water quality.
The Coase theorem works as follows. First, suppose that a neutral third party creates a legal
bargaining framework by assigning the property rights to clean water to the waterworks. The
marginal cost curve in Figure 1 represents the waterworks supply of clean water. Given that the
waterworks have the property right they supply clean water. The marginal benefit curve
represents the farmer´s demand for clean water because the waterworks have the property right
to clean water. Given that the waterworks has the rights, the farmer would compensate the
waterworks by the amount C* for each unit of pollution because C* is the willingness to pay at x*.
If the waterworks demands a higher level of compensation, C > C*, there will be a surplus of clean
water as the farmer will not demand as much as the waterworks wants to supply. If the
waterworks asks for a lower level of compensation, C < C*, there will be a shortage as the farmer´s
demand exceeds the waterworks supply. The surplus forces compensation down while the
shortage forces compensation up until the market clears at the compensation level C*. At C* the
demand for clean water equals the supply at the socially optimal level of pollution, x*.
Now suppose that the neutral third party assigns the property right to pollute to the farmer. The
MC curve presented in Figure 1 represents the waterworks demand for pollution control because
the farmer has the right to pollute while the MB curve represents the farmer´s supply of pollution
control because the farmer have the property right. Given that the farmer has the right to pollute,
the waterworks can offer a bribe to the farmer of B* for each unit of pollution control, because B*
is the willingness to pay at x*. If the farmer demands a higher bribe, B > B*, there will be a surplus
of pollution control as the waterworks will demand less pollution control than the farmer is willing
to supply. If the farmer asks for a lower bribe, B < B*, there will be a shortage of pollution control
as the waterworks will demand more than the farmer supplies. The bribe B* clears the market
since the demand for pollution control equals the supply at the socially optimal level of pollution,
x*.
Theoretically, the Coase theorem works. Regardless of the initial assignment of property rights,
the optimal per unit bribe equals the optimal per unit compensation at the socially optimal level of
pollution, x*. Thus, the market achieves the optimal level of pollution. However, the Coase
theorem depends on a number of assumptions (see Hanley et al, 1997):
a. Zero transaction costs.
b. Perfect knowledge of each other´s well defined profit or utility functions.
c. Two persons for each bargain
d. Competitive markets for legal rights.
e. A costless court system to uphold all legal contracts.
f. Profit maximizing and utility maximizing consumers.
g. No wealth effects.
The effects of relaxing these assumptions have been tested in experimental studies. Two
behavioral implications arise from the assumptions:
a. A weak behavioral outcome. Bargainers will reach a Pareto efficient agreement.
b. A strong behavioral outcome. Bargainers will reach a Pareto efficient agreement
with a rationally self-interested distribution of expected welfare.
The case in Figure 1 is an example of b. Here demand is equal to supply at the rationally selfinterested distribution of marginal welfare on C* = B*.
Two classical experimental studies are Hoffman and Spitzer (1982) and Harrison and McKee
(1985). Hoffman and Spitzer (1982) consider the following scenarios:
a. Two actors and perfect information.
b. Two actors and imperfect information.
c. Three actors and perfect information
d. Three actors and imperfect information.
Hoffman and Spitzer´s (1982) experimental results support the weak behavioral outcome.
Bargainers are highly efficient (about 90%) but the expected wealth is often split equally rather
than in the predicted self-interested manner. As mentioned above the weak behavioral outcome is
Pareto efficient. Thus, from the point of view of economics it is full satisfactory.
Harrison and McKee (1985) only consider two actors and perfect information. However, they
modify the set up in Hoffman and Spitzer (1982). More specifically the definition of property rights
in Hoffman and Spitzer (1982) is not clear. Harrison and McKee (1985) incorporate alternative
institutional arrangements of property rights and generate evidence to support the strong
behavioral outcome.
Shogren (1992) and Shogren and Kask (1992) also consider imperfect information. Both studies
conclude that the weak behavioral outcome holds under imperfect information. With respect to
the number of participants Hoffman and Spitzer (1986) show that the Coase theorem is robust up
to 38 participants.
Overall, the existing experimental studies suggest that the Coase theorem is relative robust to
changes in the assumptions. However, it is a relevant question if the Coase theorem is also robust
in real market situations. This question is examined in the next section
3. Real market transactions
This section describes the results of an interview survey conducted among Danish waterworks
about their experience with establishing voluntary cultivation agreements with farmers. In 1998,
the Danish water delivery law was changed. One of the changes was that drafting of actions plans
became mandatory for areas where a special effort is necessary to protect drinking water. These
plans constitute hereafter an important part of water protection in Denmark (Noe et al., 2003 and
Miljøstyrelsen, 2007). As a part of their implementation, waterworks can enter conservation
agreements with farmers in the affected areas. The purpose of the interview survey is to
investigate if the Coase theorem holds in a situation where Coasian bargaining has been applied in
a real market setting.
3. 1 Drinking water protection in Denmark
Nearly all Danish drinking water comes from groundwater and purification of groundwater for
drinking water purposes is rarely used in Denmark (COWI, 2001). It has been shown in a valuation
study that Danish consumers have a high willingness to pay for non-purified groundwater (Hasler
et al., 2007). This implies that protection of groundwater resources against contamination is
socially important. Regulation of agricultural land use represents an important measure for
protecting groundwater against diffuse source pollution. Contamination of groundwater with
pesticides and nitrate from agriculture are among the principle threats to the drinking water
quality. General regulations of land use are implemented by the government. These general
regulations include banning of certain pesticides, pesticide taxes, ceilings on the use of fertilizers
and manure on agricultural land and restrictions on crop rotations. However, such general
regulations may not protect groundwater from being contaminated by pesticides or nitrate in
areas with vulnerable groundwater resources. The farmer has the right to use permitted pesticides
and quantities of fertilizers even though this may lead to pollution of the groundwater under the
land cultivated by the farmer. In other words, the farmer has an implicit right to pollute
groundwater.
With the changes in the Danish Water Supply Act in 1998 (Miljøministeriet, 1998), the regional
authorities are required to make action plans for catchment areas with vulnerable drinking water
resources. The plans define which areas are vulnerable to contamination by nitrate and pesticides4
and where additional measures are necessary for protection of the groundwater. The new water
supply act also introduced the possibility that waterworks make voluntary agreements with
farmers about their land use. Such agreements could include, among other things, restrictions on
the use of pesticides, reduced used of fertilizers and manure, and afforestation measures.
Purchase of land in cooperation with local municipalities was also allowed with the new
regulation.
Consequently, waterworks have three options when they face a risk of pollution of their water
resources induced by agricultural land use, i.e.:
a. Purchase of agricultural land
b. Voluntary management contracts with farmers
c. Exploitation of alternative water resources.
A fourth alternative, purification of contaminated water is generally not considered as an
acceptable solution. The third option where water resources in other regions are exploited is
often prohibitively costly. Furthermore, in the eastern part of Denmark the demand for water is
high relative to the available resources implying that there may not be any local non-used
resources.
With purchase of agricultural land, the first option, the waterworks are free to decide the use of
the land, or in other words, the negative externality of land use on groundwater is internalised.
Purchase of land is typically followed by afforestation implying no use of pesticides and fertilizers.
However, purchase of land is only possible in areas where actions plans have been approved. The
process of preparing and approving action plans has turned out to be very slow. Only about 50% of
the expected actions plans were approved in 2010 (Vangsgaard 2010). This more than 10 years
after the new law was implemented.
4
However, the Danish Environmental Agency have still not defined the criteria for appointing pesticide vulnerable
zones, implying that only nitrate vulnerable zones have been appointed (Kristensen 2008)
Furthermore, purchase of land is not an option in areas where the groundwater quality is
threatened by pesticide use because the pesticide vulnerable zones have still not been defined by
the regulatory authorities. Since pesticides are considered as the main risk factor by most
waterworks, voluntary agreements with farmers are often the only possible approach to the
protection. No additional protections measures are, of course, also an option. The social cost of
this alternative depends on the expected risk of contamination with the current land use and the
costs of moving to use alternative resources.
The waterworks are non-profit utilities which set cost-based prices on water supplied to
consumers. They are either owned by the consumers or the local municipalities. The main
objective of waterworks is, therefore, to provide clean drinking water to the local inhabitants to
the lowest possible price. However, one can imagine that waterworks owned by municipalities
may also address other objectives, e.g. improving recreational facilities for local inhabitants. This
was given as a reason by some waterworks for preference over afforestation contracts.
In 2001 the two organisations representing the waterworks and the agricultural organisations
agreed on general standards for the design of contracts and how the compensation paid by
waterworks should be calculated (Dansk Landbrug, 2001). Standard compensation rates were
calculated for different farm and contract types by an independent research institution (Dubgaard
and Mortensen, 2001). The compensation is based on farmers’ income loss implied by a contract.
However, it was acknowledged that even with rather detailed calculations of standard compliance
costs for different measures there would be a need for estimation of costs for each individual
farm. Even with individually calculated compliance costs there is, however, still a significant
uncertainty about the real costs because it will not be possible to take into account all factors
(e.g. management skills of the farmer) having an impact on costs.
In the cases, where the measures negotiated with the farmer is in accordance with the approved
actions plans, the waterworks may enforce compulsory implementation or purchase of the farm
land if the farmer rejects “reasonable” conditions (compensation). A compulsory purchase
(expropriation) has to be carried out in cooperation with the local municipality and agreement
based on voluntary negotiations should first have been sought according to the Environmental
Protection Act. However, the threat of compulsory purchase has only been invoked in a few
situations, e.g. in Aalborg (Kristensen 2008), where additional protection includes measures
against nitrate pollution and an action plan has been implemented. These are the necessary
conditions if compulsory purchase is to be applied.
3.2. Method
In 2005, there were 2,622 common drinking water supply utilities in Denmark, of which the local
public authorities owned 158 and 2,464 were owned by consumers' co-operatives (DANVA, 2007).
There is no central registration of water works which have sought to establish cultivation contracts
with farmers. Therefore, in order to identify water works that have experiences with cultivation
agreements larger waterworks or local authorities in all Danish municipalities have been
contacted. The largest water works, i.e. the suppliers of drinking water to the largest cities, have
been contacted directly. They are most likely to have attempted to make contracts, according to
initial interviews with the two organizations that represent the Danish waterworks (DANVA,
representing the largest waterworks, and the Association of Waterworks in Denmark, representing
the smallest water works). To identify other smaller waterworks with potential experiences with
cultivation contracts local authorities responsible for monitoring of the drinking water supply were
contacted. Based on their information waterworks were contacted and a telephone interview was
carried out with the manager or board members of the waterworks. We cannot exclude the
possibility that waterworks have entered cultivation negotiations but have not been included in
the survey. However, our judgment is that the main part of the waterworks having experiences
with negotiations of voluntary agreements is included in the survey.
In total, we carried out 45 interviews with water works. These include: 18 waterworks or supply
companies that either have entered agreements, are in a negotiation process, or have negotiated
but failed to reach an agreement. These were interviewed about the content of the contracts and
the negotiation process. It was not in all cases possible to have detailed contract information, e.g.
payments, since parts of the contract were considered confidential. Some of the interviewed
waterworks without experiences with cultivation contracts are considering making contracts in the
future while others see no threats against the quality of their groundwater resources. Even though
it is only a small part of the Danish waterworks which have been interviewed the survey cover the
main part of the Danish water supply because the utilities supplying all the main cities5 were
interviewed.
3.3. Results
Among the 18 interviewed waterworks who have experiences with negotiations with farmers
about cultivation contracts, 13 waterworks had at the time of the interview entered plans. The
size of the area covered with agreements were estimated to 587 ha (based on eleven of the 13
water works). It was not possible to get information on the size of the area covered by 6 contracts
(Aalborg and Copenhagen). However, we estimate that maximally 800 ha are covered by
agreements . Considering that one third of the Danish land area (1.5 million ha) has been
appointed as areas with special drinking water interests, the area with contracts are rather low.
DANVA who has been involved in facilitating waterworks in negotiating the contracts also
considers that the process of concluding contracts have been slow (Vangsgaard 2010).
Waterworks had applied two main approaches to negotiating with the framers. First, individual
negotiations, where both the content of the cultivation agreement and the bribe is determined,
have been used. Second, farmers have been offered standard non-negotiable agreements, where
both the cultivation restrictions and bribes are given. The farmer can then accept or reject the
offer. In some cases the waterworks have offered several standard agreements among which the
farmers could choose. Table 1 gives an overview over the negotiation approaches.
5
The water works supplying the Copenhagen region and the 14 largest towns, representing 48% of the Danish
population, have been interviewed.
Table 1: Overview over negotiation type
Negotiation type
Number of waterworks
Voluntary individual negotiation
12
First voluntary individual negotiation, later
1
standard agreement
Standard agreements
3
Agreement without compensation
1
Individual negotiation with threat of
1
expropriation
In total 13 waterworks have undertaken individual negotiations with farmers while 4 waterworks
have offered standard agreements. One waterworks has gone from negotiation of individual
agreements to offering standard agreements. Several waterworks are considering to use standard
agreements if more cultivation contract are to be concluded in the future.
One waterworks has entered an agreement about not using pesticides on 4 ha of land without
bribing the farmer. Another waterworks has entered agreements with 3 farmers where
expropriation was possible if voluntary negotiations did not lead to a result. In this paper, focus
has been on negotiation where the waterworks have not stated that expropriation is possible ,
because our focus is non Coasian bargaining. This is not the case when expropriation is possible.
The cultivation plans most often agreed upon include restrictions on the use of pesticides, reduced
use of nitrogen fertilizer, and afforestation, see Table 2.
Table 2: The content of cultivation plans.
Cultivation restriction
Number of waterworks with
Number of waterworks with
accomplished agreements
failed negotiations
No use of pesticides
9
2
Reduced use of nitrogen
5
1
1
0
Set aside of farm land
2
2
Conversion to organic farming
2
0
Afforestation
5
1
Other
1
1
fertilizer
Restrictions on number of
animals
Note: A waterworks can have several agreements and an agreement may contain several
restrictions.
7 out of the 13 waterworks that have undertaken voluntary individual negotiations with farmers
have been involved in negotiations that failed or decided consequently to change from individually
negotiated contracts to offering standard contracts. In total 55 negotiations have been conducted
out of which 39 did not lead to a result. Table 3 gives an overview of the reasons for failed
negotiations given by the waterworks.
Table 3: Reasons for failed negotiations or change in from standard agreements
Assumption
Number of waterworks
Imperfect knowledge of each other’s well-
8
defined profit or utility functions
Non-competitive markets for legal rights
2
Not cost-minimizing water works
2
Not profit maximizing farmers or not cost-
4
minimizing water works
High contract enforcement costs
4
High transaction costs
3
Remark: Waterworks could state several reasons for failed agreements.
The waterworks most common explanation of the fact that negotiations failed to achieve a result
(or changed from individually negotiated to standard contracts) was disagreement about the size
of the bribe. The waterworks estimate that in these cases the farmers’ claims were above the
income loss that cultivation plans would impose on them. According to the waterworks, they
would have accepted to pay a compensation corresponding to the real costs (without
overcompensation). For some waterworks, the claimed overcompensation implied that costs of
alternative solutions to secure clean water were lower than entering a contract and they,
therefore, disrupted the negotiations of a cultivation plan. Two waterworks explained that they
could not defend in relation to consumers to give a large overcompensation to a farmer even
though paying overcompensation to farmers still may be cheaper than other ways of securing noncontaminated drinking water. In other words, the profit maximizing (i.e. cost minimizing of
waterworks) agent assumption of the Coase theorem was violated.
A considerable share of the troubles with reaching an agreement concerning the bribe can
probably be attributed to problems with asymmetric information (eight waterworks). Even though
farmers’ organizations and the waterworks organization have agreed upon a model for
compensation calculation, it is not possible to calculate a fully objective compensation
(Foreningen af vandværker I Danmark, 2004). Calculation of, for example, yield reductions and
changes in variable costs will to some extend be based on approximations and will vary between
individual farmers (Dubgaard and Mortensen, 2000). It is, therefore, difficult for the waterworks to
determine when claims involve overcompensation. This implies that the farmers will try to exploit
their information advantage of the actual costs and demand a higher compensation than the real
income loss. According to this explanation farmers’ try to acquire a share of the possible gain
which waterworks get through avoided pollution of groundwater.
Two waterworks indicated that farmers have taken advantage of the lack of competitive markets
of legal rights by adapting a strategic behavior. One of these experienced lengthy negotiations (up
to 3 years) because each time a contract was ready to be signed the farmers returned with
demands for still higher compensation. The other waterworks had decided to cope with strategy
behavior in the way that after the initial negotiations the waterworks presented a farm specific
contract to the farmer and she/he was given two years to decide whether she/he would accept
the conditions. The waterworks had before hand indicated to the farmer that there would be no
other negotiation later.
Transaction costs for waterworks include time costs associated with negotiations and with
working out an agreement. The long negotiations have implied high costs for waterworks. Three
waterworks explained that they have chosen to use standard agreements because of lower
transaction costs compared to individually negotiated agreements.
Four waterworks mentioned enforcement of cultivation plans as a problem. It can be difficult and
associated with considerable costs to control agreements about pesticide free cultivation and
reduced use of nitrogen fertilizer. Therefore, several waterworks prefer agreements about
afforestation which is easy to control. In order to save costs of enforcement several waterworks
prefer to combine their agreement with existing general regulations such as, for example,
environmentally friendly agricultural use and organic farming which is administrated and
controlled by the Ministry of Agriculture. In such cases waterworks add a premium to the general
subsidies if the farmer is located in an area with protection interests.
According to the interviewed waterworks several farmers had rejected to enter an agreement on
grounds of principle. This could be due to previous conflicts with the municipality or waterworks
or general resistance against environmental regulation. At the same time two waterworks
mentioned that they had had few difficulties negotiating an agreement about afforestation with
part time farmer´s who also were forest workers. This underlines that economic compliance cost is
not the only criterion for the decision about entering an agreement and that farmers’ personal
preferences can both contribute to or work against an agreement. That non-economic reasons for
concluding contracts are important for some farmers has also been found by Déprés et al. (2008)
in a survey of negotiations on cultivation contracts between farmers in the French Vittel region
and a the company (Nestle) which use the ground water for bottled drinking water. They found
that there was a small minority of farmers who refused also to enter into an agreement due to
strong political commitments (Déprés et al. 2008).
3.4. Perspectives
The Coase theorem depends on assumptions such as perfect information, profit maximizing
behavior and zero transaction costs. Experimental studies show that the Coase theorem is robust
to changes in these basic assumptions. However, our study of real market transactions shows that
when these basic assumptions are not fulfilled the Coase theorem fails as a policy instrument to
internalize externalities.
In spite of the fact that farmers’ and waterworks’ organizations have agreed on guidelines for
cultivation agreements very few cultivation plans had been signed by the end of 2008. It is
estimated that approximately 800 ha are covered by cultivation plans of which 2/3 have been
entered as a result of individual agreements without the threat of expropriation. The interview
survey indicates that the limited results can be attributed to, among other things, drawn-out
negotiations and strategic behavior by farmers. The general trend is that waterworks consider
going from individually negotiated agreements to standard non-negotiable contracts. The
waterworks explained this mainly by the fact that many of them have been in long and resource
demanding negotiations which in a number of cases had ended without an agreement.
It is assumed that the drawn-out negotiations can be attributed to problems with asymmetric
information and strategic behavior by farmers. It is not possible to construct a fully objective basis
for calculating compensations because there are large differences between individual farmers’
cost structure. Since the waterworks do not have perfect information about the individual
farmer´s cost structure, the farmer will try to take advantage of the information structure to
obtain overcompensation (information rent).
Therefore, the time-consuming individually negotiated agreements lead to high transaction costs
or failure to conclude a contract. This result differs from Déprés et al. (2008) who found that even
with very complex negotiations between Nestle and farmers in the Vittel catchment area,
individually negotiated contracts were concluded in most cases (92%). However, in the Vittel case
the potential gains from agreements were considered very high and a public research team was
involved in facilitating the conclusion of contracts.
Standard non-negotiable agreements will to some extent solve the problem with asymmetric
information leading to strategic behavior by farmers. However, with the imperfect information on
farmers costs it is also difficult to design standard agreements that give full cost compensation to
all farmers without a number of farmers receiving overcompensation. Overcompensation is not a
problem from an economic efficiency point of view but the survey shows that large
overcompensations may be unacceptable by the waterworks. Standard agreements are best
suited to situations where it is not decisive for the waterworks that all agricultural land in a
catchment area is included in an agreement. In such cases farmers will have no incentives to
conceal their true cost structure, i.e. all farmers with contracting cost less than the standard
compensation can be expected to conclude a contract with the water works.
4. Conclusion
The Coase theorem states that without transaction cost the market can by itself solve externality
problems though negotiation between involved parties. This depends on, among others, the
assumptions of perfect information, maximizing behavior and the absence of transaction costs.
Existing tests of the robustness of the Coase theorem to changes in the assumptions have mostly
been conducted in experimental studies. Therefore, studies of the assumptions in real markets are
important.
The study presented here has investigated the attempts to establish voluntary cultivation
contracts between Danish waterworks and Danish farmers. We show that the Coase theorem
breaks down due to imperfect information, non-competitive markets for legal rights, non-
maximizing behavior, and transaction costs. Asymmetric information and strategic behavior are
particularly important factors in this context. Farmers will try to exploit their information
advantage to obtain overcompensation, which in turn may lead to termination of negotiations by
the waterworks. However, non-maximizing behavior and transaction costs are also important.
With non-maximizing behavior farmers will refuse to enter into agreements with waterworks on
grounds of principle. Transaction costs are also linked to the problem of asymmetric information
where farmers exploit their information advantage and thereby prolonged negotiations.
An important topic for future research is additional tests of the assumptions in real markets. It is
relevant to ask if the results in this paper can be generalize to other markets.
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