Road to the 1991 Nobel Prize in Economics
COASE (1960)
Presented by Eric Banister and Matt Panhans
What is the Coase Theorem?
 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 maximises the value of production) is
independent of the legal position if the
pricing system is assumed to work without
cost (Coase 1960, p. 8).
 The Coase theorem . . . asserts that under
perfect competition private and social costs
will be equal. (Stigler, Theory of Price, 1966, p.
113)
 if one assumes rationality, no transaction
costs, and no legal impediments to
bargaining, all misallocations of resources
would be fully cured in the market by
bargains (Calabresi 1968, p. 68
 If transaction costs are zero the structure of the
law does not matter because efficiency will result
in any case (Polinsky 1974, p. 1665).
 In sum, the Coase theorem states the following:
if the property rights to any resource are
assigned rather than unassigned, and if
exchange costs are sufficiently low, the ultimate
use of the resource is independent of the initial
assignment of the rights to the resource
(although the initial assignment of rights does
affect the wealth of the transactors involved)
(Baird 1975, p. 222, emphasis added
 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).
 in the presence of transaction costs the
location of a pollution tax or of other liability
for damages does matter for efficiency
(McCloskey, Applied Theory of Price, 1982, p.
354)
 [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) profitmaximizing producers and expected utility
maximizing consumers, (g) no wealth effects,
(h) agents will strike mutually advantageous
bargains in the absence of transactions costs
(Hoffman and 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 and Ulen 1988,
p. 105)
 a change in [law] affects neither the
efficiency of contracts nor the distribution of
wealth between the parties (Schwab 1988, p.
242)
Social context
 Reaction against “blackboard economists”
 Economics is increasingly mathematical, case
studies becoming unfashionable
 Coase read many court cases of recording
studios near noisy factories
 the theorem stood on its head a half century
of received thinking about externalities and
market failure. (Medema, p10)
Externalities before 1960 (and
still today)
 Goods whose value is more than their cost
are produced. In the presence of externalities,
this may not be the case. We need Pigovian
taxes equal to negative externality to achieve
economic efficiency.
 Coase added three things: (1) externalities are
not necessarily inefficient, (2) Pigovian taxes
are not necessarily desirable, and (3) problem
is not externalities; the problem is transaction
costs
Against Pigou’s Railway
 Perfect competition
 Firm’s perspective, not liable for damage:
 1 train/day yields revenue of $150 & costs $50 to
operate
 2 trains/day yield revenue of $250 & cost $100
 But, 1 train causes $60 in crop damage; 2 cause
$120
 Total social production value from one train:
 $150 - $50 - $60 = $40
 Total social production value from two trains:
 $250 - $100 - $ 120 = $30
Against Pigou’s Railway
 The Pigovian tradition argues one train
should run and to ensure this, the railway
operator should be made liable for damage
 Coase agrees that only one train should run,
but critically disagrees that liability is always
the optimal solution.
The Problem with Pigou
 Let bargaining be prohibitively expensive.
Whether liability is assigned now leads to
different situations.
 When railway is liable for damages, additional
cultivation means 1 train now causes $120 in crop
damage and 2 trains now cause $240 in crop
damage
 So, with liability assigned to the railway:
 1 train: $150 - $50 - $120 = -$20 (train will not run)
 2 trains: $250 - $100 - $240 = -$90 (trains not run)
 Now it is not profitable to run either train.
Approach with the Coase Th.
 Two trains, bargaining prohibited:
 Back to $120 in crop damage.
 But some land ($120 worth of crops) has been
abandoned from cultivation vis-à-vis the situation with
liability for the railroad.
 Allow that not all of the crops on that now-abandoned
land would have been destroyed, so the total value
could be $160.
 Once abandoned, the land and resources could be
used alternatively, say for uses worth $150.
 So, two trains, total social production value:

$250 - $100 - $120 - $160 + $150 = $20 profit
In Summary
 Pigovian approach: assign liability by disparity
between private & social costs and particular
deficiencies of system.
 But, “the proper procedure is to compare the total
social product yielded by these different
arrangements.” (34)
 Note the railway is not a generalized model, but is a
specific example. With different numbers, a
different result might obtain.
 And this is exactly Coase’s point:
The correct approach to policy is an opportunity cost
approach that requires knowledge of the specifics of a
given situation and weighs the benefits and costs of
“alternative social arrangements” rather than assigning
liability or levying taxes for damage automatically
Modern Day examples
 Wind turbine projects:
 Offshore of Cape Cod, MA: Electricity for 420,000 homes;
powerful critics of imposing on the natural beauty and
wildlife of Cape Cod; 81% popular support building turbines
 Appalachia: Residents have filed a nuisance suit to block
construction
 Sydney pays residents to move outside city
(ht:Traviss)
 Crowding, rising house prices, strain on infrastructure—all
have led government offer residents AU$7,000 to move
 Complexity of such projects testifies to Coase’s point
that high transaction and information costs can
prevent parties from reaching an efficient bargain
Law, Economics, & Ethics
 Encouraging a shift in law and policy: Proper
regulation “has to come from a detailed
investigation of the actual results of handling the
problem in different ways.” (18-19)
 Coase strongly encouraged the courts to understand
and be informed by the economic consequences of
their rulings and the ideas of reciprocity in liability.
 In concluding the common ground here, Coase cited
Frank H. Knight as saying, “problems of welfare
economics must ultimately dissolve into a study of
aesthetics and morals.” (43)
 Reality check: How would you react?
Problems
 Critical Assumption: no transaction costs.
even Coase (1960) acknowledged this
limitation.
 Transaction costs are everywhere. Anything
can be rationalized by transaction costs
 Fails in presence of asymmetric information
 Formalization of theory. And hopefully,
predictive successes
Development Since 1960
 Coase Theorem
 Williamson and transaction costs
 Transaction become the basic unit
 James Buchanan: the lens of choice vs. the lens of
contract approaches to economic organization
 “The Vertical Integration of Production” (1971)
 Pre-formal, semi-formal, and formal stages
 “an interesting and challenging future”
 Nanoeconomics
References
 Coase (1960)
 David Friedman, “The Swedes Get It Right,”
(1991). Link
 Medema (2010), Coase Theorem. link
 D. McCloskey note
 Williamson, Oliver. “Transaction Cost
Economics: The Natural Progression.” AER.
100 (June 2010): 673–690. also, this link
References
 http://www.boston.com/lifestyle/green/green
blog/2010/04/cape_wind_decision_expected_
to.html
 http://www.npr.org/templates/story/story.ph
p?storyId=5300507
 http://www.guardian.co.uk/world/2011/jun/29
/sydney-pays-people-to-leave