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The
Real

Coase Theorems














Glenn Fox










Department of Agricultural Economics and Business

University of Guelph


November, 2004












2



Abstract


“The
Real

Coase Theorems”


Glenn Fox, Department of Agricultural Economics and Busi
ness, University of Guelph



The Coase Theorem is one of the most widely cited ideas in modern
social science
. It has
precipitated an enormous critical literature. It is discussed in a wide range of economics
textbooks. In some respects, the theorem is

the ultimate example of successful economic
scholarship; an idea that has attracted the attention of virtually all practitioners of economics, of
many legal and political theorists and whose validity continues to be debated 40 years after the
original art
icle appeared. There is only one problem; Coase denies that he ever proposed the
theorem that bears his name. He has stated that he regrets having published “The Problem of
Social Cost”, because, in his judgment, the essay has had exactly the opposite e
ffect that he
wanted it to have. The “Coase Theorem” is widely viewed as claim about what happens in
actual human social interaction. The bulk of the controversy surrounding this proposition has to
do with specifying the conditions under which the predic
ted outcome will occur. Coase has
subsequently explained that his analysis of what would happen in a world without transaction
costs is a purely hypothetical analysis. It is not a proposition about real events. So, it would
appear that economists have m
issed the point of “The Problem of Social Cost”. But what was
Coase’s original intent? What are “The
Real

Coase theorems”? This paper examines the two
propositions that
Coase actually presented in 1960: that economists should view harm as
reciprocal and

that transaction costs provide an economic rationale for judicial and governmental
reorganization of property ownership. The purpose of this essay is to assess those two theorems.

My thesis is that there are important lessons to learn from Coase, once w
e get past a persistent
misunderstanding of what he was trying to say, but there is also much to criticize in his view.




3

Introduction


The Coase Theorem is widely recognized as a triumph of social science scholarship.
Web searches using “Coase Theorem
” as key words yield thousands of hits. Economists, legal
scholars, environmental and political scientis
ts have written volumes on the
theorem. Few ideas
written by economists in the 20
th

century have been as widely debated. There is only one
problem.
The author says that he is not the originator of the theorem. In fact, he maintains that
the theorem that bears his name conveys a message that is antithetical
to the message that he
intended.



My view is that virtually all of the criticism that econo
mists have written of Coase fails to
appreciate the actual message that he was intending to communicate and is
, therefore,
essentially
irrelevant. Because we have focused on what he was not saying, we have not grasped what he
was saying
. C
onsequently we
have not
been either sufficiently appreciative or sufficiently
critical of his actual message.


Coase on “The Problem of Social Cost”


With the publication of
The Firm, the Market and the Law

in 1988, Coase broke his
protracted silence on the way in whic
h his work had been interpreted by economists, legal
scholars and other social scientists. He laments (Coase, 1988, p. 1) that


My point of view has not in general commanded assent, nor has my argument, for the
most part, been understood. No doubt inadeq
uacies in my exposition have been partly
responsible for this and I am hopeful that this introductory essay, which deals with some
of the main points raised by commentators and restates my argument, will help make my
position more understandable. But I do

not believe that a failure of exposition is the main
reason why economists have found my argument so difficult to assimilate. As the
argument in these papers
1

is, I believe, so simple indeed as almost to make their
propositions fall into the category of
truths which can be deemed self
-
evident, their
rejection or apparent incomprehensibility would seem to imply that most economists
have a different way of looking at economic problems and do not share my conception of



1
Coase is referring to “The Nature of the Firm”, “The Marginal Cost Controversy” and “The Problem of Social
Cost”, p
apers that he contends expressed a unified point of view. This claim is critical to the interpretive analysis of
“Social Cost” that I offer later in this essay.


4

the nature of our subject. This I beli
eve to be true.


I have argued elsewhere (Fox, 1997) that Coase is a scientific realist methodologist, making him
a member of a small but not inconsequential minority among economists. He is justified in his
claim that he does not share the predominant vi
ew of the nature of economics. Among his
specific points of departure from the mainstream, he holds the view that economists’
preoccupation with studying the logic of optimal choice has caused them to neglect the study of
the institutional setting in whic
h choice takes place
2

and that this has eroded the substance of
economic research (Coase, 1988, p. 3), that human action cannot be adequately characterized as
a constrained maximization problem (Coase, 1988, pp. 3 and 4) and that modern economic
theory ign
ores the role of transaction costs
3

(Coase, 1988, pp. 6 and 7). Perhaps the most
revealing statement that Coase makes about the theorem that bears his name appears on page 13
of
The Firm, the Market and the Law
:


“The Problem of Social Cost,” in which the
se ideas were presented in a systematic way,
has been widely discussed in the economics literature. But its influence on economic
analysis has been less beneficial than I had hoped. The discussion has largely been
devoted to sections III and IV of the ar
ticle and even here the discussion has concentrated
on the so
-
called “Coase Theorem,” neglecting other aspects of the analysis. In sections
III and IV, I examined what would happen in a world in which transaction costs were
assumed to be zero. My aim in
doing so was not to describe what life would be like in
such a world but to provide a simple setting in which to develop the analysis and, what
was even more important, to make clear the fundamental role which transaction costs do,
and should, play in the
fashioning of the institutions which make up the economic
system.

Coase goes on to explain (1988, pp. 14 and 15) that a world without transaction costs is a
peculiar world, quoting Stigler (Coase, 1988, p. 14), “the world without transaction costs turns
out to be as strange as the physical world would be without friction”. The world without



2
Elsewhere, Coase (Coase, 19XX
-

look up reference) explains that the thrust of his efforts as

the long
-
time editor of
the
Journal of Law and Economics

was to encourage economists to devote more substantial efforts to the study of
the institutional setting in which choice and exchange occur.

3
Given the standard textbook criticism of “The Coase The
orem” Coase’s criticism of modern economic theory for
ignoring transaction costs should be recognized as a glaring paradox.


5

transaction costs is a hypothetical world. In that world, the world of perfect competition
4
,
monopolies would be bribed by consumers to not exploit their position of

single sellers,
insurance companies, in fact, firms in general, would not exist. In fact, economic institutions,
according to Coase, do not matter in a world with no transaction costs. But Coase’s aim, in
discussing this peculiar hypothetical world, was

to suggest (Coase, 1988, p. 15)



. . the need to introduce positive transaction costs explicitly into economic analysis so
that we can study the world that exists. This has not been the effect of my article. The
response, although disappointing, is un
derstandable. The extensive discussion in the
journals has concentrated almost entirely on the “Coase Theorem,” a proposition about
the world of zero transaction costs. This response, although disappointing, is
understandable. The world of zero transact
ion costs, to which the Coase Theorem
applies, is the world of modern economic analysis, and economists therefore feel quite
comfortable handling the intellectual problems it poses, remote from the real world
though they may be.



Many critics of Coase h
ave focused their attack on his apparent neglect of the existence
of transaction costs in the real world. But it is clear that this criticism is misplaced. Coase’s
discussion of the peculiar unreal world with no transaction costs was intended to draw out

the
strange implications of perfect competition, which he viewed as the central perspective in
modern economic analysis. Sections II through IV of “Social Cost” were intended as a critique
of economic theory circa 1960. They were not intended as a repre
sentation of the real world. So
much of the criticism that has been directed at “Social Cost” misses the mark. Later (p. 174) in
The Firm, the Market and the Law
, Coase writes the following remarkable passage;


The world of zero transaction costs has oft
en been described as a Coasian world.
Nothing could be further from the truth. It is the world of modern economic theory, one
which I was hoping to persuade economists to leave. What I did in “The Problem of
Social Cost” was simply to shed light on some

of its properties. I argued in such a world
the allocation of resources would be independent of the legal position, a result which
Stigler
5

dubbed the “Coase Theorem”: “...under perfect competition private and social



4

George Stigler seems to be the first person to use the expression “The Coase Theorem” in print, in the 1966 edition
of his
The T
heory of Price
. Stigler’s discussion of the Coase Theorem appears on pages 111
-
114, where he uses this
term as a synonym for perfect competition.

5

Coase references Stigler’s
Theory of Price

as the source of this statement.


6

costs will be equal.” . . Economists
, following Pigou whose work has dominated thought
in this area, have consequently been engaged in attempt to explain why there were
divergences between private and social costs and what should be done about it, using a
theory in which private and social c
osts were necessarily always equal. It is hardly
surprising that the conclusions reached were often incorrect. The reason why economists
went wrong was that their theoretical system did not take into account a factor which is
essential if one wishes to a
nalyze the effect of a change in the law on the allocation of
resources. This missing factor is the existence of transaction costs.



Coase offers the following interpretation of “Social Cost” in his Nobel lecture (Coase,
1992, p. 717);


Pigou’s conclusi
on and that of most economists using standard economic theory was (and
perhaps still is) that
s
ome kind of government action (usually the imposition of taxes)
was required to restrain those whose actions had harmful effects on others (often termed
negative

externalities). What I showed in that article [“Social Cost”], as I thought, was
that in a regime of zero transaction costs, an assumption of standard economic theory,
negotiations between the parties would lead to those arrangements being made which
wou
ld maximize wealth and this is irrespective of the initial assignment of rights. This is
the infamous Coase theorem, named and formulated by George Stigler, although it is
based on work of mine. Stigler argues that the Coase theorem follows from the stan
dard
assumptions of economic theory. Its logic cannot be questioned, only its domain (Stigler,
1989, pp. 631
-
3). I do not disagree with Stigler. However, I tend to regard the Coase
theorem as a stepping stone on the way to an analysis of an economy with

positive
transaction costs. The significance to me of the Coase theorem is that it undermines the
Pigouvian system. Since the standard economic theory assumes transaction costs to be
zero, the Coase theorem demonstrates that the Pigouvian solutions are
unnecessary in
these circumstances. Of course, it does not imply, when transaction costs are positive,
that government actions (such as government operation, regulation, or taxation, including
subsidies) could not produce a better result than relying on n
egotiations between
individuals in the market. Whether this would be so could be discovered not by studying
imaginary governments but what real governments actually do. My conclusion: let us
study the world of positive transaction costs.


Earlier in his
Nobel lecture, Coase explained (p. 717) that his hope was that the ultimate impact
of “Social Cost” would be transform the structure of microeconomics.


Other Criticisms of Coase


In addition to criticisms of Coase for ignoring the existence of transactio
n costs in the

7

real world, he has also been upbraided for ignoring the wealth and income effects from changes
in ownership or liability. Many attempts to disprove the Coase Theorem amount to
demonstrations that income or wealth effects of one sort or anot
her would alter prices,
production, individual well being and other phenomena when ownership or liability changes.
But like the charges regarding his alleged neglect of transaction costs, these criticisms miss the
mark. If Coase is not telling a story ab
out the real world in Sections II through V, then the
existence of income or wealth effects in that real world
would
not contradict his point. The
economic theory th
at

Coase is attacking had not, for the most part, ignored wealth or income
effects. It ha
d, in his estimation, ignored transaction costs.


Unrealism of the Theory of Perfect Competition


To Coase, a world without transaction costs is the world of perfect competition. He uses
the expressions “the pricing system works smoothly” (1988, p. 97,
p. 100, similarly p. 102, p.
112), “the operation of a pricing system is without cost” (1988, p. 97, similarly p. 102 , p. 104, p.
106 and p. 114) and “If the crop was previously sold in conditions of perfect competition” (1988,
p. 98, similarly twice on p
. 101) as interchangeable. The equation of perfect competition and a
world without transaction costs is not unique to Coase. Stigler does the same thing. In the first
recorded reference to “The Coase Theorem”, Stigler (1966, p. 113) writes


The Coase T
heorem thus asserts that under perfect competition private and social costs
will be equal. It is a more remarkable proposition to us older economists who have
believed the opposite for a generation, than it will appear to the younger reader who was
never
wrong, here.


This puts many of Coase’s critics in a difficult position. Those who would argue that the
conditions under which the Coase Theorem would apply are unlikely to ever be realized must
also argue with equal enthusiasm, if they are to be consiste
nt, that the conditions under which
perfect competition would occur are also unlikely ever to occur. If the Coase Theorem cannot be
used as a measuring stick against real world situations, then neither can perfect competition. Of

8

course, this was exactly

Coase’s point. His exposition of a hypothetical world without
transaction costs was developed precisely to illustrate this paradox intrinsic to the theory of
perfect competition. Perfect competition requires perfect information. Perfect information
eli
minates transaction costs. But this perfect information means that every member of a society
must know, without effort and with perfect accuracy, all of the potential parties with whom he or
she might enter into a market exchange as well as the terms of e
xchange that would be
acceptable as well as the trustworthiness of all of these potential exchange partners. It is the
absence of just this information that gives rise to transaction costs in the first place.


The practical implications of this criticis
m are explored in section VIII of the essay in
Coase’s critique of Pigou. The problem of using perfect competition as a standard for evaluating

the performance of an existing situation is found to be deficient (Coase, 1988, p. 142).



The Pigouvian analy
sis shows us that it is possible to conceive of better worlds than the
one in which we live. But the problem is to devise practical arrangements which will
correct defects in one part of the system without causing more serious harm in other
parts.


It sho
uld now be clear that criticism of the Coase theorem that interprets the theorem as
making claims about what happens in the real world is misplaced. Coase’s exposition of the
implications of ignoring transactions costs was intended as a criticism of econo
mic theory circa
1960. This criticism seems to be equally valid today. Economic theory that does not
acknowledge the existence of transaction costs and that does not fully integrate the effects of
those costs on the structu
re of that theory is deficient.

This implies that vir
tually everything that
appears i
n our economics textbooks and much of what appears in economics journals about
Coase is, at best, irrelevant.



On the Definition of Transaction Costs


Coase is generally acknowledged
6

as introducing

the concept of transaction costs into the



6
My own view is that Menger’
s analysis of the marketability of commodities in his 1871
Principles of Economics

(1871/1976, pp. 241
-
256) and his related theory of the origin of money (pp. 257
-
285) should be recognized as an

9

economics literature in his 1937 essay “The Nature of the Firm”.
However, he continues to
lament that his exposition of t
he
nature
of transaction costs for economic analysis has
not had the
effect that he had hop
ed
on the orientation of economic research
. In his view,
economic theory
still
has not fully integrated the idea of transaction costs. This is not to say that economists have
not written a great deal on the subject. Unfortunately, much of what has been
written has not
been adequately informed by the way that Coase defined the phenomenon. As a result, current
economic literature on transaction costs is incoherent.


Two definitional issues are important. First, according to Coase, transaction costs a
rise
only in market exchange. They represent the value of the resources that are used up in the
process of conducting a market exchange. Modern literature on transaction costs has applied the
term to other phenomena with unfortunate consequences. It is
commonplace for economists to
use the term transaction costs to refer to the value of the resources used up in the process of
institutional change, including changes in government policy. For example, Douglass North and
Oliver Williamson have frequently r
eferred to the value of resources used up in organizational
and institutional change as transaction costs. While it is correct to acknowledge that institutional
and policy changes are costly, it would be better to have a separate term to describe these co
sts.
The main reason that it is important to maintain the distinction between transaction costs as part
of the process o
f

market exchange and the costs of institutional change is that, for the most part,
the mechanism generating the costs is fundamentally

different. Transaction costs arise under
conditions of

bilateral voluntary exchange of property. For the most part
7

the new institutional






earlier insight into the nature and significance of transacti
on costs. In fact, in “The Nature of the Firm” (
The Firm,
the Market and the Law
, 1988, p. 42), Coase treats “marketing costs” as a synonym for transaction costs. In his
Nobel lecture (Coase, 1992, pp. 716
-
717), Coase offers a transaction cost based mone
tary theory that is reminiscent
of Menger’s monetary theory (Menger, Chapters VII and VIII).

7
Institutional change can occur, as Hayek has explained, through the evolution of an existing spontaneous order, and
hence can occur within that realm of voluntar
y transactions among consenting adults. For the most part, however,
the institutional change literature pioneered by Coase, Demsetz, North and Williamson does not make a consistent
and clear distinction between institutional change in a spontaneous order
and in a planned order. However, in
practice, most examples of institutional change studied in this literature involve planned orders and hence lie outside
the realm of voluntary transactions among consenting adults.


10

economics has focused on changes brought about through the political process

or to the costs of
changes in institut
ional structures within firms.
These institutional changes involve costs, but the
nature and the interpretation of the costs involved differ from those arising under voluntary
exchange.


A second important Coasian definitional boundary that is almost un
iversally transgressed
in current literature has to do with the categories of costs that make up transaction costs. In his
1937 essay
8
, Coase enumerated three categories of transaction costs (1988, p. 38, 39): the cost of
discovering what the relevant pri
ces

are
, the costs of negotiating the terms of an exchange and
the cost of concluding that exchange. We now refer to the costs of discovering what the relevant
prices are as search costs. Search costs are the value of the resources used up as we try to f
ind
potential partners for bilateral or multilateral voluntary exchanges. Negotiation costs consist of
the value of the resources used up in the process of trying to reach mutually satisfactory terms
for exchanges with those potential partners. Concludin
g costs represent the value of the
resources used up in making sure that the partners with whom I have entered into a voluntary
exchange have in fact delivered the goods.


Unfortunately, terminological drift has occurred and many contemporary economists
call
this third transaction cost category monitoring and enforcement costs. This has lead to needless
confusion. Unlike Coase’s original use of the term “concluding” costs, monitoring and
enforcement costs suggest that the parties are involved in an ongo
ing commercial relationship.
In that relationship, they need to make sure that other participants are in compliance with the
negotiated agreement. But from a Coasian point of view, an ongoing commercial relationship is
a contract. If that contract takes

the form of authorizing one factor owner to direct the
production activities of other factor owners, then this would be, in Coasian terms, a firm.
Coase’s explanation for the existence of firms is that these ongoing contractual relationships are
an alter
native to market transactions and that by entering into such relationships people can avoid



8
Page numbers used in reference to
“The Nature of the Firm” are from version of this paper reprinted in
The Firm,
the Market and the Law
.


11

transaction costs. But these relationships are not free. Developing and maintaining relationships
to sustain ongoing commercial interaction uses up resources. Th
ese resources have values and
their use has an opportunity cost. One of the elements in this categories of cost is monitoring,
making sure that the parties in the relationship are living up to the obligations that they agreed to
assume as parties to the r
elationship. Monitoring costs are a category of what Coase calls
coordination costs within the firm. Other categories include the costs of managerial or
entrepreneurial error
-

the costs that the firm incurs when managers think that an opportunity to
mak
e profit exists, mobilize factors of production that are part of the firm to pursue that
opportunity but it subsequently turns out that the managers perceptions were wrong. So, by
calling the third category of transaction costs monitoring and enforcement
costs, which is
commonplace, we run the very real risk of losing the essence of the distinction between the firm
and the market

that Coase introduce in “The Nature of the Firm” in 1937
.


Transaction costs figure prominently but not exclusively
9

in Coase’
s explanation for the
existence of firms as social institutions. In “The Nature of the Firm” Coase explains that “there
is a cost to using the price mechanism” (Coase, 1988, p. 38). One of the elements of this cost is
the cost of “discovering what the re
levant prices are” (Coase, 1988, p. 38). In addition, there are
“the costs of negotiating and concluding a separate cont
r
act for each exchange transaction which
takes place in a market” (Coase, 1988, pp. 38
-
39). Coase’s exposition could be easily
misunde
rstood if taken out of context, since he used the term “contract” in two quite different
senses in his theory. In the quotation above, “contract” refers to an agreement for a single
market exchange. Coase’s “concluding” cost represent the costs of makin
g sure that the terms of
that single market exchange transaction have been satisfied. For example, if I agree to by a cow
from someone, when that cow is delivered and I make payment, concluding costs would involve
me making sure that the cow that was deli
vered was indeed the one that I agreed to buy and the



9
Coase also acknowledges the role of the preferences of some people to have their work directed by others, of other
people to be the directors of such wo
rk, risk aversion and the differential treatment under taxation and regulations of
transactions that occur within firms compared to within markets as factors encouraging the emergence of firms as
social institutions.


12

buyer making sure that the cheque that I used to pay for the cow cleared. The key distinction is
that the relationship that the seller and I have, with respect to that cow, is over.


Later (Coase, 19
88, pp. 38
-
40) Coase uses the term “contract” in a different sense.
Specifically (Coase, 1988, p. 39)


A factor of production (or the owner thereof) does not have to make a series of contracts
with the factors with whom he is co
-
operating within the firm,

as would be necessary, of
course, if this co
-
operation were a direct result of the working of the price mechanism.
For this series of contracts is substituted one.


A “contract” in a single market exchange involves concluding costs. A contract in a firm
, on the
other hand, involves a sustained relationship, a commitment to ongoing co
-
operation in a
commercial activity and this contract involves co
-
ordination costs by the entrepreneur. This
durable contract, according to Coase, most typically involves th
e provision of labour services.


In Coase’s theory, the boundaries of the firm, in a general sense how big a firm becomes,
is determined by the interplay of transaction costs and coordination costs. Transaction costs are
incurred in market exchanges. A
s the costs of transacting in market exchange fall, relative to
coordination costs, firms tend to get
smaller,

since it is less costly to obtain the services of
factors of production through a market exchange than it is to bring the owners of those factors

of
production into the set of relationships that is the firm. There are several reasons why
transaction costs might fall. The most commonly offered explanation is the advance of
information technology. According to this explanation, as computer hardwar
e and software
improved and as computer networking systems evolved and developed, the costs of search in
particular have fallen. This would suggest that the boundaries of firms should shrink. On the
other hand, advances in computer systems and networks c
ould also reduce the internal costs of
coordination within firms and reduce those costs as well. So a more complete Coasian theory
might
be ambivalent about the general effects of advances in information technology on the
boundaries of firms.


13


There are

other factors that influence the level of transaction costs. These have not
attracted much attention from economists, but work in the tradition sometimes referred to as
Social Capital is related. For example, the level of search costs will be influenced

by the
existence of free
10

media (print, broadcast, mail, e
-
mail, internet) as means for people to signal
willingness to transact to other members of a society with whom they do not interact personally,
identifiable communities of interest (trade associati
ons, ethnic, religious and social
organizations, recreational organizations) which serve as means of identifying and contacting
groups of potential
exchange partners
.


The level of negotiation costs would be influenced by a tradition of protecting privat
e
property and enforcing contracts, thus encouraging potential parties to an exchange to negotiate
in good faith. It also reduces the risk for people who reveal what they might be willing to offer
in exchange out of fear that someone might just take it fr
om them. This tradition can also reduce
negotiation costs if it raises people’s confidence in making market transactions. There is
generally more fear involved in the first purchase of a large item, like a house, than subsequent
purchases. The transacti
on costs per vehicle are likely lower for someone who buys a new car
every two years than for someone who buys one every 10 years.


Concludin
g

costs may be influenced by a shared value of honest de
aling in a society.
Reputation and trust
can play a role

in this environment. Repeated dealings, or the prospect of
repeated dealings
,

provide an incentive for people to fulfill their parts of an agreement to
exchange. As the costs of coordination fall, relative to transaction costs, the firm tends to expand
in order to economize on the relatively expensive transaction costs.


I offer these provisional examples for two reasons; first, to illustrate that social and
institutional context can influence the level of transaction costs in a particular community an
d
second, to show how little progress has been made on Coase’s mission to transform the structure
of microeconomics. Virtually no attention has been paid in the economic research agenda to



10
I am using the term “free” in the sens
e of not subject to government censorship or control, as opposed to the sense
of available at a zero price to users.


14

improving our understanding of those factors th
at

influence transa
ction costs. Dahlman (1979)
has suggested that the primary purpose of economic research should be to identify ways of
reducing transaction costs, but that suggestion has not been generally taken up.


Although the distinction between verification of conclu
ding market transaction costs is
clear enough in “The Nature of the Firm”, later (Coase, 1988, p. 6) Coase quotes, with apparent
approval, Dahlman’s (1979, p. 148) three
-
fold enumeration of market transaction costs of
“search and information costs, bargai
ning and decision costs, policing and enforcement costs”.
In addition, in “The Problem of Social Cost”, (Coase, 1988, p. 114) Coase describes transaction
costs in the following terms:


In order to carry out a market transaction, it is necessary to discove
r who it is that one
wishes to deal with, to inform people that one wishes to deal and on what terms, to
conduct negotiations leading up to a bargain, to draw up the contract, to undertake the
inspection needed to make sure that the terms of the contract a
re being observed, and so
on.


The meaning of “policing and enforcement costs” is less clear than concluding costs. It is
unfortunate that Coase chose the phrase “the terms of the contract are being observed” as
opposed to “the terms of the market exchang
e contract have been satisfied” and inclusion of “and
so on” does nothing to clarify the distinction between concluding or verification costs and other
types of costs. But if we accept Coase’s view that “The Nature of the Firm” and “The Problem
of Social
Cost” express essentially the same point of view, then, while the passage from “Social
Cost” quoted above may not be sufficiently clear taken in isolation, if we read “Social Cost” in
light of “The Nature of the Firm”, di
scernment
of its meaning is less p
roblematic.


The contemporary practice of referring to the third category of transaction costs as
monitoring costs rather than verification or concluding costs is inconsistent with Coase’s
explanation of the existence of the firm and with his theory of t
he firm’s boundaries. The i
dea
that the value of the resources used up in monitoring compliance with an ongoing commercial
relationship constitute
s an category of
transaction costs leaves nothing for the firm to balance

15

against transaction costs in the de
termination of its boundaries. If monitoring costs are
transaction costs then the boundaries of the firm are constrained only by the costs of managerial
or entrepreneurial error.


The Legacy of “The Problem of Social Cost”


The degree of consensus among
economists and legal scholars on what constitutes the
core message of “The Problem of Social Cost” is remarkable. Textbooks and articles are
virtually unanimous.
This continues to be the case today, 16 years after Coase’1 1988 disavowal
of virtually all
that had been written about him and a dozen years after his Nobel acceptance
lecture.
The consensus view on “The Problem of Social Cost” can be summarized as follows.
Coase’s analysis of a world with negligible transaction costs is an analysis of existi
ng situations.
There is no acknowledgment of the contradictions between assumptions of rational behavior,
zero transaction costs and a finding that under these circumstances unrealized gains from
exchange can exist and persist. Criticism of the Coase the
orem generally focuses on whether the
case of zero or of negligible transaction costs is sufficiently commonplace to make Coase’s
analysis applicable.


George Stigler and ‘The Coase Theorem’


The first time that the expression “The Coase Theorem” appeared
in the economics
literature was on page 113 of the third edition of George Stigler’s
The Theory of Price

(Stigler,
1966). It appears in a section on ‘Private and Social Costs” that begins, ironically, by invoking
the Pigouvian analysis of pollution. Havi
ng laid out the external cost analysis following Pigou,
Stigler proceeds to introduce Coase’s wandering cattle illustration from “The Problem of Social
Cost”. The importance of this seamless transition, in the present context, is that it fails to
acknowle
dge the purpose that Coase himself clearly declares in “Social Cost”. Pigou is Coase’s
frequent if not constant target in “Social Cost”. His claim is that the pervasive influence of the
point of view of
The Economics of Welfare

had been harmful to econom
ists understanding of the

16

nature of external cost problems and that economists preferred remedies for external costs
generally did more harm than good.


Most of the written tradition in economics textbooks and articles follows the Stiglerian
interpretati
on. Stigler uses this expression at the end of a two page recapitulation of Coase’s
cattle raising example from “The Problem of Social Cost”. The whole quotation in which this
phrase appears is instructive.


The manner in which the law assigns liability
will not affect the relative private marginal
costs of production of cattle and grain.


But this procedure obviously leads to the correct social results
-

the results which would
arise i
f

the cattle and grain farms were owned by the same man.

The Coase th
eorem

thus
asserts that
under perfect competition

private and social costs will be equal. It is a more
remarkable proposition to us older economists who have believed the opposite for a
generation, than it will appear to the younger reader who was never w
rong

.

.


The proposition that the composition of output will not be affected by the manner in
which the law assigns liability for damages seems astonishing. But it should not be. . .


The proposition must, to be sure, qualified by an important fact. W
hen a factory spews
smoke on a thousand homes, the ideal solution is to arrange a compensation system
whereby the homeowners pay the factory to install smoke reduction devices up to the
point where the marginal cost of smoke reduction equals the sum of the

marginal gains to
the homeowners. But
the costs of this transaction

may be prohibitive
-

of getting the
people together, of assessing the damages, and so on
-

so only a statutory intervention
may be feasible. (Stigler, 1966, pp. 113
-
114, emphasis added)



Note the smooth transition from a discussion of the hypothetical and impossible world of perfect
competition in economic theory to statements about the real world of laws and liability rules.
Stigler is caught in the Coasian paradox.
The
assumption o
f
economic rationality
combined with
the omission of transaction costs as a functional and meaningful component of economic theory
render the welfare economists pathologies of efficiency vacuous
.
T
he presence of transaction
costs is not a “qualification”
to the proposition, it is a fundamental criticism of the then and
currently dominant theory.


When Stigler introduces the term “the Coase Theorem” he treats it as a synonym for

17

perfect competition (p. 113, para 2). Unfortunately, he fails to see that Co
ase’s aim in the 2
nd

through the 5
th

sections of “Social Cost” is to point out that a world without transaction costs,
that is, a world where the conditions of perfect competition h
o
ld, would be a peculiar world
indeed. In the third paragraph of page 113
of
The Theory of Price
, Stigler offers a defense of
what he thinks is a perplexing inference of Coase
-

that an initial pattern of ownership and
liability rules have no influence on production, prices or consumption in equilibrium
-

in which
he attempts to

convince his reader that in the real world “Laws often prove to be unimportant”.
Stigler understands Coase’s discussion of a world without transaction costs to represent the real
world.


Stigler
does not integrate
Coase’s 1937 essay on the role of tran
saction costs in the
economic rationale for the existence of firms

with his discussion of “Social Cost”
. In his
discussion of “The Functions of the Firm” (Stigler, 1966, pp. 168
-
171),
he does invoke
Coase’s
analysis of transaction costs and the costs of i
nternal coordination as factors influencing the
boundaries of the firm. But the
implication
that a world without transaction costs is a world
without firms, is not acknowledged.
And Stigler’s qualification of the proposition that
differences in liability

rules have no effect on outcomes, quoted above, reaches exactly the
conclusion of what I have called the Second
Real

Coase theorem. In the presence of transaction
costs, statutory intervention might improve efficiency, since voluntary transactions might
not
take place.


Coase in Context


Ronald Coase introduced the idea of transaction costs to the economics literature in 1937
i
n

“The Nature of the Firm”. That paper is cited with increasing frequency as the seminal
contribution to the exploding literatu
re on theories of the firm produced by business researchers
and economists in the last 25 years. Previous authors, in retrospect, had discussed concepts
closely related to what we now call transaction costs. For example, Menger (1871/1951) in his
discuss
ion of the marketability of commodities
, a discussion that
that served as the foundation

18

for his theory of money, wrote about the differences in time and effort associated with market
exchanges of different types of commodities. But Coase is justifiably c
redited with raising
economists’ awareness that resources are used up simply in the process of making market
exhanges.


Even on this point, however, Coase’s original insight has been obscured by the common
practice among economists of defining transaction
costs as the sum of search costs, negotiation
costs and enforcement costs
11
. “The Nature of the Firm” was written as a response to a novel
and fundamental question. “Why do firms exist?” With a few notable exceptions like Frank
Knight (1921), economists h
ad shown little interest in this question prior to 1937. In fact, they
continued to show little interest in the question for forty years after “The Nature of the Firm”
was published. If pressed, the rationale economists would offer for the existence of t
hese social
institutions called firms is that they exist to earn profits. This answer is not completely
satisfactory for two reasons. First, individuals can earn profits without going to the trouble of
organizing a firm. Secondly, as Coase explains, the

firm is a curious institution that, at least to
some degree, ignores the information available in market prices. How can this be a good

thing

economically
? Coase’s rationale for the existence of firms resolves this paradox. Firms are
sustained relation
ships among owners of factors of production. These owners have contractual
relationships with one another, possibly coordinated through someone called an entrepreneur
12
.
The terms of these relationships may be recorded in written contracts or they may be
implicit.
The terms describe who is responsible for doing what within the firm and how compensation for
owners of productive factors is to be paid. Both the responsibilities and compensation are
determined internal to the firm. At any given point in tim
e, they may not coincide with factor
prices or employments observed in market transactions external to the firm. Establishing and
maintaining these relationships is not easy. It takes time and effort.




11
Coase attributes this definition (Coase, 1988, p. 6), apparently with approval, to Dahlman (1979).

12
Coase does not make a clear distinct
ion between the functions of entrepreneurship and of management in the firm.



19

Why would owners of factors of production and entre
preneurs go to the trouble

of
creating firms
? The
answer,
according to Coase, is transaction costs. Production

could take
place without firms. Adam Smith’s pin factory could operate as follows. One person could dig
ore out of the ground and sell it to
someone with a wagon and a horse. That person, in turn,
could cart the ore to a sea port where they could be sold to a ship owner. The ship owner could
sail to some other port and sell the ore to a smelter. The smelter could sell steel to a person who
m
anufactures wire, the wire manufacturer could sell wire to someone who specializes in cutting
wire to pin
-
like lengths. These pieces of wire could be sold to someone who sharpens one end to
a point. This process could continue up to final delivery of pin
s to end users.

Transaction costs are incurred at each point where the goods in process pass from one
owner to the next

through a free market exchange
. Firms can avoid these transaction costs by
establishing
ongoing
relationships among owners of factors

of production employed in
successive stages of the production process. Once these relationships are developed, it is no
longer necessary to search for potential exchange partners nor is it necessary to negotiate the
terms of those exchanges. The transac
tion costs disappear. However, new costs arise that did
not occur in my hypothetical “production by the market” situation. The firm will need to
monitor and enforce the terms of the contractual relationships among the factor owners involved
in the firm.

The firm avoids transaction costs in securing the services of the inputs brought into
the firm, but it incurs management and coordination costs in making sure that those inputs are
doing what they are supposed to do.

In addition, the firm incurs costs w
hen the entrepreneur or the manager makes a mistake,
directing inputs in a particular way that is different from what market prices and factor
employments external to the firm indicate and it turns out that those markets where right and the
entrepreneur wa
s wrong. So avoiding transaction costs is a mixed blessing. Coase goes on to
explain that the boundaries of the firm
13

are determined by weighing transaction costs with



13
Today we might say the “size, scale and scope of the firm”.


20

coordination costs at the margin. Does adding a new factor owner to the set of relati
onships that
make up the firm reduce transaction costs by more than it increases coordination costs? If it
does, the firm should expand by absorbing the services of that factor of production. The limit to
this expansion is reached when no further net cos
t savings can be achieved through continued
agglomeration.


This is a rather long exposition of Coase’s answer to the question “Why do firms exist?”,
but there is a reason for going into this much detail. “The Nature of the Firm” is a key to
understandi
ng “The Problem of Social Cost”. “The Nature of the Firm” explains that firms exist
to economize on transaction costs. Coase offers this explanation to fill a gap in economic theory
circa 1937. There is no convincing rationale for the existence of firms

in economic theory
because transaction costs are not acknowledged by that theory. To Coase, this omission is
crucial, because, in the real world, transaction costs are pervasive. “The Problem of Social Cost”
was published 23 years later. That paper beg
ins with five sections that discuss a world without
transaction costs. Understanding the nature of the world Coase is addressing in these
introductory sections is critical to a correct understanding of what this later paper is all about. If
the world wit
h negligible transaction costs is intended to describe a common situation in the real
world, then the standard textbook treatment of the paper is correct. But a world without
transaction costs, according to Coase, is a world without firms. Without transa
ction costs to
avoid, there is no reason to go to the trouble of organizing firms. Firms did not disappear
between 1937 and 1960. Coase, the man who so eagerly introduced the concept of transaction
cost to fill what he saw as a significant deficiency in
economic theory, does not argue that
transaction costs had, by 1960, disappeared. So if we are to make sense of “The Problem of
Social Cost” in light of the context of Coase’s other work, we need another explanation. The
world of negligible transaction c
osts discussed in the first five sections of “The Problem of
Social Cost” is not the world in which we live.


Paradox Lost


21


Daniel Farber (1997) has offered an alternative interpretation of “The Problem of Social
Cost” which, while rendering virtually al
l of economists’ commentary on the original paper
irrelevant, has the additional advantage of relating the 1960 essay consistently to Coase’s other
writing. According to this revisionist interpretation, Coase is presenting a parody in sections 1
through 5

of the essay. It is a parody of economic theory, especially welfare economics and the
categories of pathologies of inefficiency commonly studied in that area of specialization.
According to this view, Coase begins the essay by describing the world as ch
aracterized by
economic theory. This world, to his regret, even in 1960, is a world in which transaction costs
are not acknowledged. The absence of transaction costs in the welfare economics of 1960
creates an inconsistency. On the one hand, economists
talk about categories of inefficiency in
resource use like externalities, public goods and monopolies, but, in the absence of transaction
costs, none of these pathologies could persist. Inefficiency means, among other things, that
potential mutually benef
icial gains from exchange are not being realized. In the absence of
transaction costs, people will make the relevant mutually beneficial exchanges and the pathology
will disappear. Since transaction costs are not even acknowledged in the theory, let alon
e being
adequately integrated into it, economists cannot explain why the pathologies that they had taken
such great pains to characterize might exist other t
han for brief periods of time. And if they half
-
heartedly acknowledge that transaction costs may p
revent these gains from exchange from being
realized, they are still stuck, because if transaction costs are real opportunity costs, then they can
no more be a source of inefficiency that can the opportunity cost of any more commonly
recognized factor of p
roduction.



Eugene Silberberg’s (1978) discussion of the Coase theorem is the textbook treatment
that comes closest to capturing the essence of
the intended
the message of the first five sections
of “The Problem of Social Cost”. Silberberg (1978, p. 494
) clearly identifies the paradox in the
new welfare economics that was the motivation for Coase’s essay.


. . the new welfare economics as outlined above is deficient in terms of incomplete
specification and logical consistency. The fundamental postulate
s of economics are

22

maintained throughout. Consumers are presumed to possess utility functions with the
usual properties; ie. they prefer more to less, convexity etc. Most importantly, there are
no costs of transacting or contracting between consumers in
this analysis. Yet somehow
consumers are supposed to get together and
not

exhaust the gains from trade in certain
circumstances. But how can this be? If all consumers prefer more to less and there are
no contracting costs,
Pareto optimality is necessari
ly implied
. To say otherwise is to
deny the fundamental postulates of economics, most probably a premature stand to take.
The only way the gains from exchange will not be fully exhausted is if consumers are
somehow prevented from exhausting them by the e
xistence of positive transaction costs.


Silberberg (1978, pp. 494
-
495) goes on to explain


It is often claimed that ‘tariffs misallocate resources’, urban areas are ‘overcrowded,’ the
atmosphere and water supplies are ‘overpolluted,’ etc. It is less fr
equently asked why
individual maximizers would ever do these things to each other. Indeed, in a world
without transaction costs, they would not. All of which says that the enunciation of
conditions under which the gains from trade will be exhausted under

the assumption of
zero transaction costs is apt to be a sterile endeavor.


The assumption of zero transaction costs is an assumption of the new welfare economics, not a
new idea introduced by Ronald Coase in 1960. The first five sections of Coase’s 1960

essay do
not tell a story about the real world. They tell a story about the hypothetical world of the new
welfare economics.


The
Real

Coase Theorems


Section VI of “The Problem of Social Cost” opens with a statement that
should have cast
a long shadow

of doubt on the canonical interpretation of the essay. The opening two sentences
of this section are;


The argument has proceeded up to this point on the assumption (explicit in sections III
and IV and tacit in section V) that there were no costs involve
d in carrying out market
transactions. This is, of course, a very unrealistic assumption.


This is a remarkable and
remarkably unnoticed


statement. According to Coase, the preceding
discussion, which concluded that the initial assignment of ownership in

a world devoid of costs
of transacting had no impact on the equilibrium outcome, was not a discussion of the world as it

23

is. After these opening sentences, Coase reiterates his characterization of the nature of
transaction costs and in doing so clearly i
ndicates their pervasiveness in actual market
transactions. So what has come to be called “The Coase Theorem” was never intended to tell us
anything about the way that the world actually works. The question “When does the Coase
Theorem apply?”, according

to Coase, should always be answered “Never!”, since transaction
costs are ever with us. The world without transaction costs is the artificial world of perfect
competition.



However, there is much
more to the message of “The Problem of Social Cost” tha
n the
observation that economic theory has steadfastly ignored the existence of a real phenomenon
called transaction costs. In section II of “Social Cost”, Coase proposes to overturn the
longstanding concept of harm based on a linear understanding of caus
ality and responsibility and
to replace it with a process that assigns liability for harm on the basis of cost benefit analysis. In
section VI of

the essay, Coase articulates an
economic theory of judicial and legislative action.
These two ideas are the
real

Coase theorems. They are substantive claims about the way the
world should work and, to some extent, about the way that the world does work. With a few
noteworthy and welcomed exceptions, these propositions have been ignored by economists.



Real Co
ase Theorem 1

The harm recognized as a negative externality should be interpreted as reciprocal.

According to Coase, the traditional interpretation of the nature of the relationship
between the polluter (eg. the firm that releases smoke into the atmosphere
) and the pollutee (eg.
the home owner downwind) is that the polluter has harmed the pollutee. The intent of the
Pigouvian tax was to make the polluter take into account the nature and magnitude of this harm.
In his first theorem, Coase claims that this
understanding of the relationship between the harmer
and the harmed is incorrect. He proposes (Coase, 1988, p. 96)


The traditional approach has tended to obscure the nature of the choice that has to be
made. The question is normally thought of as one in

which A inflicts harm on B and

24

what has to be decided is, How should we restrain A? But this is wrong. We are dealing
with a problem of a reciprocal nature. To avoid harm to B would be to inflict harm on A.
The real question to be decided is, Should A

be allowed to harm B or should B be
allowed to harm A? The problem is to avoid the more serious harm.


Later (Coase, 1988, p. 132)


What has to be decided is whether the gain from preventing the harm is greater than the
loss which would be suffered els
ewhere as a result of stopping the action which produced
the harm.

Coase acknowledges that this view of the nature of the problem is a departure from that
traditional law of nuisance and trespass
14
. Coase’s view is a generalization of what is known as
the
Hand formula
15
. The Hand Formula assigns liability for damages from an accident by
comparing the costs of taking precautions that would prevent the accident to the probability of
the accident occurring multiplied by the size of the loss incurred as a resu
lt of the accident. If the
cost of precaution is less than the product of the probability of the accident and the value of the
loss, then the party for whom this condition holds is liable. The view, generalized by Coase,
makes responsibility for harm hin
ge on the balancing of utilities
16
.


Coase has claimed that his goal in writing “Social Cost” was to restructure
microeconomics. But his first theorem restructures justice
17
. He acknowledges that his
perspective is unconventional and he claims that the
conventional perspective is wrong headed.





14
See Brubaker (1995) and Rothbard (1982) for economic treatments of the problem of negative externalities based
on

trespass and nuisance law that reject the Coasian approach.

15
See Posner (1998, p. 180
-
183) for an exposition of the Hand Formula.

16

Daniel Farber (1997) has argued that Coase’s views on legal theory and social policy are consistent with
pragmatism. My
view is that there is considerably more evidence that Coase is a utilitarian. I would describe Coase
as a practical utilitarian. Being an active participant in the discussions about the nature of opportunity costs at the
London School of Economics in the

1930's, Coase should be well aware of the subjective nature of those cost as
factors influencing human action
16
, so he must recognize that pure welfare
-
textbook utilitarianism, in which all of
the changes in utility consequential to some government action
are summed to see if there is a net gain or loss, is
impossible. Coase’s compromise solution is to compare situations on the basis of the sum of the market value of all
of the goods and services exchanged without the government action with the correspondi
ng sum with the action to
see if that action increased that more operational measure of aggregate welfare.


17
See North (1992, 2002) and Block (1977, 1995, 1996, 2000) for discussions of the ethical implications of Coase’s
first theorem.


25

Real Coase Theorem 2


In a world with positive transaction costs, judicial activism or legislative action has
the potential to increase efficiency by re
-
allocating property to higher valued uses
when transaction

costs prevent this occurring through voluntary exchange.

Section VI of “Social Cost”, ironically titled “The Cost of Market Transactions Taken Into
Account”, begins (Coase 1988, p. 15)


The argument has proceeded up to this point on the assumption
18

(exp
licit in Sections III
and IV and tacit in Section V) that there are no costs involved in carrying out market
transactions. This is, of course, a very unrealistic assumption.


Later in the section, Coase (1988, pp. 16
-
17) proposes


It is clear that an al
ternative [ie. an alternative to market exchange] form of economic
organization which would achieve the same result at less cost than would be incurred by
using the market would enable the value of production to be raised . . An alternative
solution is dir
ect government regulation. Instead of instituting a legal system of rights
which can be modified by transactions on the market, the government may impose
regulations which state what people must or must not do and which have to be obeyed.

Contrary to Coa
se’s reputation as an opponent of government intervention, this second theorem
is an economic rationale for government regulation
.

Coase suggests that, in the real world,
transaction costs and all, there is a potential efficiency enhancing role for governm
ent, a role that
had not been previously identified in the welfare economics literature. Coase draws an analogy
between government and the firm. The parallel quality is that they can both be means of
economizing on transaction costs. In the case of the
firm, transaction costs are avoided by
setting up a system of contracts among owners of factors of production so that it is not necessary,
moment by moment in the production process, to purchase the services of those productive
factors through market excha
nge. According to Coase, governments can reduce or even
eliminate certain categories of transaction costs through regulation. A market transaction
approach in which new home owners moving into a new subdivision located next door to a



\
18
There are at lea
st 8 separate times when the assumption of no transaction costs is stated in sections III, IV and V
of “Social Cost”.


26

factory would likely

involve substantial transaction costs, if every household had to negotiate a
deal with the factory owner and with all of the other households to pay the factory to install
equipment to reduce emissions. Governments, through their claimed monopoly on the
use of
legitimate force, face lower transaction costs. In particular, they would face much lower
negotiation costs.


Corollary to Real Coase Theorem 2


Real Coase Theorem 2 should be applied with caution since actual judicial and state
actions may make
matters worse


Coase is quick to point out, also in Section VI of “Social Cost”, that there is a limit to the
extent to which the government can improve efficiency by avoiding transaction costs, just as
there is a limit to the expansion of the boundaries o
f the firm. His analysis anticipates Wolf’s
theory of non
-
market or policy failure and much of the modern public choice. Coase reminds his
reader that the use of government power to reduce transaction costs and internalize external costs
through regulati
on is subject to pathologies. People make policy decisions in government and
they may not be guided solely by the mythical public interest when they do so. Much of the
remaining discussion in “Social Cost” is devoted to an examination of how these pathol
ogies
have worked them out in particular cases, especially in the particular case of the train, the sparks
and the farmers discussed by Pigou. Coase explains that the exemption from traditional
standards for liability enjoyed by the railways in Britain wa
s a product of legislative action. He
suggests that this condition, he calls is legalized nuisance (p. 127) accounts for a significant
share of perceived external cost environmental problems. So the possibility of using government
regulation to reduce tr
ansaction costs and improve efficiency in internalizing external costs is a
two
-
edged sword. So, according to the second real Coase theorem, the power to impose
regulatory solutions on members of a community can be used to improve efficiency. But there i
s
no guarantee that it will be consistently used to do so.




27


Criticism of the
Real
Coase Theorems


The First Real Coase Theorem


Once we recognize Coase’s proposition about the reciprocal nature of harm as his first
real

theorem, a serious problem beco
mes apparent. Coase offers no proof for this
proposition
.
He
offers no evidence, no supporting references, no reasons and no
argument
.
He dismisses the
traditional classical liberal theory of property rights and its related theory of ethics
19

but he offe
rs
nothing to convince his readers that his
activist
utilitarian theory is superior to the classical
l
iberal theory that he rejects.


He states this proposition in a general way, suggesting that there are no limits to its
application. This implies that,

as a general principle of justice, it should also be applied to other
issues, like robbery, assault, fraud and extortion. According Coase’s first
real

theorem, we
cannot conclude that the murderer, the rapist, the robber or the cheat has harmed the perso
n that
we have traditionally viewed as “the victim” until we have undertaken a cost benefit analysis.
Yes, the murderer has reduced the utility of the person who was murdered, but restraining the
murderer from murdering would also constitute a reduction i
n utility, for the murderer. Until we
calculate the changes in utility, it is premature to conclude who the victim is. This is the
implication of Coase’s reciprocal harm theory. Now Professor Coase might defend his
real

first
theorem by explaining that
he only intended its scope of application
in situations that economists
have traditionally described as externalities. But Murray Rothbard (1982) has explained that
there is no reason to separate externalities from other closely related justice issues in
this way.
And, in any case, in his statement of his first
real

theorem, Professor Coase gives no clear
limitation on the scope of its application.


The Second
Real

Coase Theorem




19
“[T]he ‘doctrine of lost grant’ is about as relevant as the colour of the judge’s eyes” (Coase, 1988, p. 114)


28


In his second
real

theorem, Professor Coase offers an economic rationale fo
r government
intervention in the market process. This intervention could be accomplished either by legislation
or by the courts, in Coases’ view
20
. By virtue of its unique role in human society, it can reduce
or eliminate transaction costs

and thereby im
prove efficiency. Government (and/or the courts)
can direct resources to their more highly valued uses when voluntary exchange seems to get
stuck. A critical weakness in this rationale for government intervention is that it is silent on the
question “But

how do they know?” How can the courts or the legislatures know what the better
pattern of resource use is, in the absence of market prices as indicators of value? This is a
variation on the challenge that Mises and Hayek made to proponents of economic c
entral
planning. H
ow can judges or legislatures know the most valued use of property if preferences
are subjective

and if knowledge is distributed among members of society in the manner that
Hayek (1945) claimed
?

J
udges and Legislatures face the same pro
blems that Mises and Hayek
concluded would confront the economic planner

in the absence of market prices.


Omission of discussion of the implications of the economic calculation debate from
Coase’s exposition of his second
real

theorem is puzzling on two

grounds. First, Coase himself
is critical of economists who do what he called “Blackboard Economics”. Blackboard
economics occurs when economists draw cost curves or supply and demand curves and
implicitly assume that they know the relevant relationship
s with sufficient empirical basis to
identify different and superior equilibrium situations to recommend policy change. Coase was
quite critical of this hubris. But he opens himself to this same criticism with his second
real

theorem. The second irony o
f this second
real

Coase theorem is that Coase was affiliated with
the London School of Economics when the economic calculation debate was taking place and
made contributions to the literature on the subjective nature of opportunity costs. But he makes



20

Coase does not distingui
sh between legislative law and common law when he refers to the courts serving in this
transaction cost economizing role. Benson (1990), Hayek (197X) have explained the differences in both the
historical origins of these two distinct sources of law. More

recently Brubaker (1995), Yandle (XXXX) and Meiners
and Yandle (19XX) have shown that common law, traditionally dismissed by environmental economists as an
inefficient means of environmental protection,
has been more effective in addressing externality pr
oblems than
economists have typically recognized and they have also argued that the potential exists to restore common law
property rights to their previous effective role.


29

no

connection between these ideas and his analysis in “Social Cost”.


A second criticism of this activist utilitarian rationale for government intervention is that
it creates d
ynamic incentive problems
.
Walter Block and Gary North have criticized Coase’s
pr
oposal for the reallocation of property on many grounds, including
these
dynamic incentive
effects. If owners of property know that some of their property might be taken by the courts or
by the legislature if either a judge or legislators decided that tha
t property was more valuable
being used by someone else, then those current owners might exercise less careful stewardship
over their property than would be the case if they knew that their consent
21

was required before
transfer of property would take place
. Demsetz (1979, pp. 106
-
107), whose thinking is closely
aligned with Coase, acknowledges this dynamic incentive effect problem, but fails to provide a
satisfactory solution. He suggests that the rearrangement of property not be done too frequently,
but
offers no criteria to help us decide when rearrangement has become too frequent.


The Corollary to the Second Real Coase Theorem


To his credit, Coase is quick to point out that there are risks associated with the potential
application of his second
real

theorem. Offering a public choice style perspective, he warns his
readers that the regulators, “operating without any competitive check” (1960/1988, p. 118),
might be captured by well organized interests and act in a fashion contrary to the goal of
incre
asing utility. He also acknowledges the problems of general regulations applied broadly
that may not necessarily help matters in particular locations. And he suggests, like Buchanan
and Stubblebine and Wolf were to argue later, that some problems are not

worth fixing in the
sense that the costs of the obtaining the solution would be greater than the benefits realized. But
none of these warnings addresses the “But how would they know?” problem. How would we
know, objectively, if the regulators, captured
by organized interests, acted contrary to the goal of
efficiency, in the absence of market prices?
If

the second real theorem is not operational, how



21
See Randy Barnett (1992, 1998) on the importance of consent in the transfer of p
roperty.


30

could we ever practically heed the warning in the Corollary?


What to do?


If Pigou is wrong
,
because he
ignored transaction costs and failed to investigate the
institutional context of the problems he studied, and thus mis
-
diagnosed the causes
,
and Coase is
wrong
,

because of the flawed idea of reciprocal harm and
because his
proposal for judicial and
legisla
tive intervention

does not explain how the regulators can solve the economic calculation
problem,
what can economists contribute to the analysis of external costs?

Too much of the
discussion in contemporary environmental economics has pitted a Pigouvian v
iew of the world
against a Coaseian view, implicitly assuming that the discipline faced a choice between only
these two competing alternatives. Terry Anderson, an economist whose work on Free Market
Environmentalism I have admired for years, has recently
(Anderson, 2004) posed the question in
just this way. But, if you accept my argument to this point, neither the Pigouvian nor the
Coasian path offers much promise. Not to worry. Labouring away in almost total obscurity, a
group of innovative economists
has been developing a third way. This third option is embodied
in contributions like
Murray Rothbard’s “Law, Economics and Air Pollution”, Randy Barnett’s
“The Function of Several Property and Freedom of Contact”
,
Elizabeth Brubaker’s
Property
Rights in D
efense of Nature

and
Bruce Yandle’s
Common Sense and Common Law for the
Environment
. Taking neither the Pigouvian nor the Coaseian approach entirely, these
economists have examined the origins of environmental conflicts and have studied the theoretical
an
d practical aspects of using decentralized common law remedies to resolve those conflicts.
This work has proceeded in a manner that takes the information issues identified in the economic
calculation debate seriously. It has also addressed the informatio
nal and ethi
cal problems of
utilitarianism and has undertaken a comparative analysis of that ethical theory with classical
liberalism and legal positivism, an analysis that sheds considerable light on the pitfalls of
Coase’s reciprocal theory of ethics.



31

Discussion

and Implications


I have read “The Problem of Social Cost”
, in its entirety, more than
40 times. I consider
the paper to be a classic contribution to the social science literature, not because of its long list of
citations, many of which I hav
e argued above fail to acknowledge its essential messages, but
because every time I read it I seem to see something important that I had not noticed before.


“Social Cost’ is on the reading list for my fourth year natural resource economics course.
Befo
re we tackle the essay, I ask students to tell me what they know about Coase. They are able
to recapitulate what they have heard about this thing called “The Coase Theorem” and they are
also usually able to summarize the main criticism
:
that Coase ignore
d transaction costs and that
therefore his “Theorem” is of little practical relevance for the real world. I have never had a
student in my class who had actually read even a portion of the essay itself. I then assign the
introductory chapter of
The Firm,

the Market and the Law
, as well as “Notes on the Problem of
Social Cost”

(Coase, 1988)
as a homework reading assignment. In the next class I ask students
to describe

Coase’s
tone as he writes about the essay that is at least 50% responsible for his
Nobel

Prize. They are generally surprised to feel his pain. We then spend up to
six (50

minute
)
discussion classes talking about “Social Cost”. I assign sections of the essay as homework
reading assignments and then lead a discussion about what Coase has to
say in each of the
sections.

At the end of the two weeks, I ask students to describe their own feelings about what they
have learned. I am frequently surprised by their anger. Their dissatisfaction is directed at all of
the previous second hand comment
ators that told them a story about Coase’s ideas that they have
found to be inconsistent with what Coase actually wrote. Among other things, the object lesson
of this exercise is to demonstrate that there is not substitute for the study of original source
s in
critical thinking.


Like my students, I have concluded that the economics literature on “The Problem of
Social Cost”, for the most part, misses the point. The almost exclusive focus on whether Coase’s
claims about what happens in a world without tr
ansaction costs apply to the real world is

32

irrelevant. Coase never claimed to be talking about the real world when he discussed the zero
transaction cost case. He was actually criticizing what he saw as the conventional practice in
economic theorizing.
By limiting their attention to only one aspect of sections II through V of
the essay, the realisticness of the zero transaction costs assumptions, economists have let Coase
get away with his more substantive proposals; first, that harm should be seen as a
reciprocal
relationship and not in terms of the classical liberal view of causality and liability, and second,
that judicial and legislative intervention in the ownership of property should be allowed,
admittedly with caution, in the interest of improving
efficiency. Walter Block and Gary North
are rare exceptions to this generalization. Based on the influence of Posner’s work and others,
Coase’s first theorem and the Hand Formula that preceded it have restructured a great deal of
modern law. Coupled wit
h the influence of legal pragmatism of the type advocated by Farber, a
critical social institution has been deliberately reorganized in the United States and Canada
without the benefit of sustained economic analysis of the consequences.


The second real
Coase theorem has been similarly ignored by economists. It has not been
examined in light of Hayek’s (1945) exposition of the nature of knowledge in human society, nor
in light of Barnett’s related analysis of the importance of consent in the transfer of
property. The
question of making Coase’s proposal operational in light of the subjective nature of utility,
including opportunity costs
22

has been virtually ignored. Walter Block, again, is a noteworthy
exception to this sad generalization. The failure o
f economists to contribute effectively to the
analysis of this theorem has not prevented courts and legislators from putting the second real
Coase theorem into action
23
, usually without much regard for Coase’s corollary to his second
real theorem.


It is
past time for economists to revise their lecture notes and textbooks and to change the
way that they write introductions for their journal articles when they make reference to Ronald



22
See James Buchanan (1969) for an examination of the subjectivity of opportunity costs.

23
See Richard Schwindt (1992) for an example of this process in the Canadian context.


33

Coase. We have had ample evidence since at least 1988 that most of what
we have had to day
about professor Coase has been irrelevant. But the tradition of debating the practical scope of
application of this thing called “The Coase Theorem” continues. Coase is an insightful critic of
the theory of perfect competition, a theor
y that he found to be logically conflicted and that has
served as a poor guide for economists trying to understand the world around them. We need to
engage him in his criticism of perfect competition. If his criticism is valid, then we have even
more to
change in the way that we go about our scholarly work. But we also need to engage
Professor Coase on the other substantive propositions that he has made, not only in “Social Cost”
but elsewhere. With respect to research strategy, he has challenged us to
devote more time to
understanding the institutional structure within which market exchange takes place. He claims
that we still have not fully integrated transaction costs into economic theory. He also claims that
we should reconstruct justice along acti
vist utilitarian lines and that
its ability to economize on
transaction costs represents an economic rationale for government intervention in the market
process. Some of these Coasian claims have merit, and, as I have argued in this paper, some do
not. B
ut they are big ideas. They deserve more serious attention from economists than they
have received so far.


34

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