Legal Theory Lexicon: The Coase Theorem
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Introduction
This week the Legal Theory Lexicon investigates the Coase theorem. Ronald Coase is a member of the law and economics faculties at the University of Chicago and a winner of the Nobel Prize in Economics. The idea that we call the Coase Theorem was advanced in a very famous paper:
Coase, R.H., The Problem of Social Cost, Journal of Law and Economics 3, 1-44 (1960).
Externalities
To understand the Coase theorem, we first need to introduce another idea, the externality. Roughly speaking, an economic externality is cost imposed by an activity that is not accrued by the person or firm who engages in the activity. That’s a mouthful. Here’s an example:
The Reading Railroad has track that goes by Farmer Jones’s farm. The locomotives cast off sparks that cause a fire that damages Farmer Jones’s crop, imposing a cost on Jones of $100. That cost is an externality.
If the Reading Railroad owned the farm, then it would bear the cost, and there wouldn’t be an externality. Before Coase, we thought that the existence of externalities justified some kind of government intervention. For example, we could create a liability rule that required the Reading Railroad to pay for the damage to his crops. Without a liability rule, the railroad wouldn’t have any incentive to prevent the damage if there was a cost-effective means of doing so. Let’s add a fact to our hypothetical:
The Reading Railroad can purchase and install a 100% effective spark arrestor for $50.
We want the railroad to install the spark arrestor for $50 to prevent $100 worth of damage. Before Coase, we said, “internalize the external diseconomies!” Really! That is, use tort law to transform the external cost imposed by the railroad into an internal cost.
Transaction Costs
This is where Coase came in. But to understand what Coase said, we need to add another bit of economic jargon. By transaction cost, we mean the cost of reaching a bargain. In the real world, lawyers are frequently part of transaction costs, but the time and expense that it takes to strike a deal are transaction costs as well–even if you don’t actually lay out any cash. One more little move, if we assume that there are zero transaction costs, we are simply assuming that it costs absolutely nothing to strike a deal–no time, no effort, no lawyers, not even any paper on which to write it up.
Coase said, “Let’s assume zero transaction costs!” Okey dokey, what next!
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