The real Coase theorems.

• Author: Fox, Glenn
• Position: Critical essay

The "Coase theorem," in one respect, is a triumph of social science scholarship. Web searches using "Coase theorem" as key words typically yield over 100,000 hits. Economists, legal scholars, environmentalists, and political scientists have written volumes on the theorem. Few ideas written by economists in the 20th century have been as widely debated. And the debating continues, 47 years after the publication of "The Problem of Social Cost" (Coase 1960), the essay recognized as the source of the ideas in question. There is only one problem: Ronald Coase maintains that the theorem that bears his name conveys an idea that is antithetical to the message that he intended.

My view is that virtually all of the criticism of the Coase theorem fails to appreciate the actual message that Coase intended with "Social Cost" and is, therefore, essentially irrelevant. Tragically, because we have focused on what he was not saying, we have not grasped what he was saying. Consequently we have been neither sufficiently appreciative nor sufficiently critical of his actual message.

Coase on the Problem of Social Cost

With the publication of The Firm, the Market and the Law (Coase 1988), a collection of essays which republished "The Problem of Social Cost" and "The Nature of the Finn" and which also included insightful reflections on the legacies of those articles, Coase (1988) broke his protracted silence on the way in which his work had been interpreted by economists, legal scholars, and other social scientists. He contends, "My point of view has not in general commanded assent, nor has my argument, for the most part, been understood." He attributes this lack of understanding to the fact that "most economists have a different way of looking at economic problems and do not share my conception of the nature of our subject" (Coase 1988: 1). 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 which choice takes place and that this has eroded the substance of economic research, that human action cannot be adequately characterized as a constrained optimization problem, and that modern economic theory ignores the role of transaction costs (Coase 1988: 3-7).

Perhaps the most revealing statement that Coase (1988: 13) makes about the theorem that bears his name is the following:

"The Problem of Social Cost" ... 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 article 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 that a world without transaction costs is a peculiar world in which, among other things, firms would not exist (Coase 1988: 14-15). In fact, economic institutions, according to Coase, do not matter in a world without transaction costs.

Many critics of Coase have focused their attack on his apparent neglect of the existence of transaction costs in the real world. But 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 representation of the real world. Thus, much of the criticism that has been directed at "Social Cost" misses the mark. Coase (1988: 174) writes:

The world of zero transaction costs has often 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 [1966: 113] dubbed the "Coase theorem." ... 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 costs 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 analyze 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: 717):

Pigou's conclusion and that of most economists using standard economic theory was (and perhaps still is) that some 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 ... 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 would 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 standard assumptions of economic theory. Its logic cannot be questioned, only its domain (Stigler 1989: 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 negotiations 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. Coase went on to explain that his hope was that the ultimate impact of "Social Cost" would be to transform the structure of microeconomics.

Other Criticisms of Coase

In addition to criticisms of Coase for ignoring the existence of transaction costs in the real world, he has also been upbraided by many writers 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 another 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 about 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 that Coase is attacking had not, for the most part, ignored wealth or income effects. It had, 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: 97, 100, 102, 112), "the operation of a pricing system is without cost" (1988: 97, 102, 104, 106, 114) and "If the crop was previously sold in conditions of perfect competition" (1988: 98, 101) as interchangeable. The equation of perfect competition and a world without transaction costs is not unique to Coase. Stigler makes the same connection. In the first recorded reference to the "Coase theorem," Stigler (1966: 113) writes

The Coase theorem 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 fact 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 consistent, that the conditions required for perfect competition 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 course, this was exactly Coase's point. His exposition of a hypothetical world without transaction costs was developed precisely to illustrate the paradox intrinsic to the theory of perfect competition.

Perfect competition requires perfect information. Perfect information eliminates transaction costs. But this perfect information means that every member of a society must know, without...