Educating Alice: Lessons from the Coase theorem

Date06 September 2000
Published date06 September 2000
AuthorSteven G Medema,Richard O Zerbe
Steven G. Medema and Richard O. Zerbe Jr.
The Coase theorem has fascinated, perplexed, comforted, and infuriated both
economists and legal scholars for more than three decades. In 'The Problem of
Social Cost' (1960), Ronald Coase argued that, from an economic perspective,
the goal of legal decision making should be to establish a pattern of rights that
would generate an efficient allocation of resources. This in and of itself is by
no means non-controversial, as about twenty years of debate between law and
economics scholars and those legal scholars of traditional and radical bents
attests. But this point was overshadowed when Coase, using his now-famous
example of crop damage caused by straying cattle, noted that once legal rights
are fully specified, negotiations between affected parties will lead to an
efficient outcome under the standard assumptions of competitive markets
(especially, zero costs of transacting) - and that this outcome will be unaffected
by the decision as to whom rights are initially assigned. In Coase's words,
it is necessary to know whether the damaging business is liable or not for damage caused
since without the establishment of this initial delimitation of rights there can be no market
transactions to transfer and recombine them. But the ultimate result (which maximizes the
value of production) is independent of the legal position if the pricing system is assumed
to work without cost (Coase, 1960, p. 8). 1
The debate over the validity of this proposition has been raging ever since.
The literature dealing with the Coase theorem is simply enormous, and even
after more than three decades the debate over the theorem is still going strong.
Research in Law and Economics, Volume 19, pages 69-112.
Copyright © 2000 by JAI/Elsevier Inc.
All rights of reproduction in any form reserved.
ISBN: 0-7623-0308-5
The literature is dominated by theoretical arguments, but within the last fifteen
years or so there have been a significant number of studies which attempt to
assess the applicability of the theorem in experimental and empirical contexts.
The purpose of this essay is to examine these three-plus decades of literature
dealing with the Coase theorem - not so much with the goal of passing
judgment on the various claims for and against its validity (although we shall
do this as well), but, rather, in the attempt to clarify the underlying importance
of the Theorem and the application of these insights to economic analysis.
2.1. Theorem(s)
The first formal statement of the Coase theorem (and its public naming) came
in 1966, when George Stigler (1966, p. 113) introduced the topic in his text on
price theory and suggested that 'The Coase theorem ... asserts that under
perfect competition private and social costs will be equal'. The theorem has
been stated in numerous ways subsequent to its initial formulation, including:
... if one assumes rationality, no transaction costs, and no legal impediments to bargaining,
misallocations of resources would be fully cured in the market by bargains (Calabresi,
1968, p. 68, emphasis in original).
•.. in a world of perfect competition, perfect information, and zero transaction costs, the
allocation of resources in the economy will be efficient and will be unaffected by legal rules
regarding the initial impact of costs resulting from externalities (Regan, 1972, p. 427)•
If transaction costs are zero the structure of the law does not matter because efficiency
will result in any case (Polinsky, 1974, p. 1665).
•.. if there were (a) no wealth effects on demand, (b) no transaction costs and (c) rights to
pollute or control pollution, the allocative solution would be invariant and optimal,
regardless of the initial assignment of rights (Frech, 1979, p. 254).
In a world of zero transaction costs, the allocation of resources will be efficient, and
invariant with respect to legal rules of liability, income effects aside (Zerbe, 1980, p. 84).
•.. a change in a liability rule will leave the agents' production and consumption decisions
both unchanged and economically efficient within the following (implicit) framework: (a)
two agents to each externality bargain, (b) perfect knowledge of one another's (convex)
production and profit or utility functions, (c) competitive markets, (d) zero transactions
costs, (e) costless court system, (f) profit-maximizing producers and expected utility
maximizing consumers, (g) no wealth effects, (h) agents will strike mutually advantageous
bargains in the absence of transactions costs (Hoffman & Spitzer 1982, p. 73)•
•.. when parties can bargain together and settle their disagreements by cooperation, their
behavior will be efficient regardless of the underlying rule of law (Cooter & Ulen 1988,
p. 105).
Educating Alice: Lessons from the Coase Theorem
•.. a change in [law] affects neither the efficiency of contracts nor the distribution of wealth
between the parties (Schwab, 1988, p. 242).
While in many ways similar to one another, these statements of the theorem
contain important differences, many of which are at the heart of the theoretical
debates over the theorem. 2
Nonetheless, a casual reading of these statements reveals two general claims
about the outcomes. The first is the 'efficiency hypothesis': regardless of how
rights are initially assigned, the resulting allocation of resources will be
efficient. The second claim - the 'invariance hypothesis' - is that the final
allocation of resources will be invariant under alternative assignments of rights.
The debates over the correctness of the Coase theorem, and/or its proper form,
have turned on both of these hypotheses, and this struggle has been manifest in
the current tendency to appeal to two different versions of the theorem - the
'strong' version, which encompasses both the efficiency and the invariance
propositions, and the 'weak' version, which encompasses the efficiency
proposition only. 3
2.2. Implication I: Externalities
When Coase undertook his analysis, he was concerned with economists'
framework for the treatment of externalities and market failure. A. C. Pigou's
(1932, p. 173) original elaboration of this framework argues that a divergence
between the values of marginal private and marginal social net product would
not 'make the national dividend a maximum; and consequently, certain specific
acts of interference with normal economic processes may be expected.., to
increase the dividend'. It is not too much of an exaggeration to say that this
approach has generated a sort of syllogism that goes, 'externalities are the
source of market failure, market failure suggests government intervention, and
thus government intervention is suggested by externalities'. This syllogism is
not as much in evidence now as it was when Coase was writing - due in large
part to Coase, but it is still prominent. In one of the leading textbooks on the
new science of policy analysis, David Weimer and Aidan Vining reach a
conclusion that appears frequently in the literature:
When is it legitimate for government to intervene in private affairs? In the United States,
the normative answer to this question has usually been based on the concept of
- a circumstance where the pursuit of private interest does not lead to an efficient
use of society's resources or a fair distribution of society's goods (Weimer & Xrming, 1992,
30; MacRae & Wilde, 1985, 170).

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