The Coase Theorem is an odd relic in the field of economics. When I first saw it in my intro-to-micro class, I thought it was a bit silly. For those that don’t know, the Coase Theorem basically says that given a set of assumptions (perfect competition, no transaction costs, no income effects, etc..), a market under the influence of externalities will maximize the value of production regardless of how property rights are assigned among the market participants*.

Like most models in your into-to-micro class, the assumptions are pretty ridiculous and simply don’t hold in any real world setting. But that’s my inner scientific realist speaking. Many economics professors will tell you that the primary purpose of a basic supply-and-demand model is to teach the intuition behind economic theory – to demonstrate how certain variables (in this case price and quantity) move together. Real world stuff just complicates the picture, you know, the typical instrumentalist creed. However, I still couldn’t square how the Coase Theorem fit into to this mindset. The conclusion of the model depended on its assumptions and this time it actually mattered. Once you relax the assumption of perfect competition or introduce transaction costs, the theorem falls apart. What’s the point of that? So when I first came across the Coase Theorem, I shrugged it off as a tool with little to no application. When I started reading the actual work of Ronald Coase, that only made things worse. His much ignored writings on the importance of transaction costs didn’t square at all with the Coase Theorem.

But when I recently re-read Coase, it turned out I was wrong, sort of. What he intended the theorem to be and what it became are two very different things (I still contend that what the Coase Theorem became isn’t useful at all). However, the way Coase used it was actually quite interesting.

Anyone that closely reads his article, *The Problem of Social Cost,* will realize that the Coase Theorem is a critique of the Pigouvian approach to externality problems. As Steven G. Medema observes:

The zero transaction costs world of the Coase theorem is merely one of the means to an end for Coase, that end being the goal of focusing economists’ attention on what he sees as the wrong- headed nature of the Pigouvian approach and, specifically, Pigou’s claim that externality problems should be resolved (and can only be resolved) through taxes, subsidies, or regulations. The zero transaction costs world is a world without frictions, a world where markets function perfectly. It is the world of mainstream economic theory, the body of theory that has so whole-heartedly embraced the work of Pigou. What Coase in- tended with his analysis of the zero transaction costs world was to show that in such a world, Pigouvian remedies (e.g., taxes, subsidies, and regulations) are not necessary to resolve externality problem.

(Medema 1994: 209)

When transaction costs are zero, law or government policy is irrelevant. The parties involved will always bargain to some socially optimal outcome. As a result, the Pigouvian remedies of taxes and subsidies are completely pointless. It’s basically an “even if” type argument. Even if we assume the world is the way a Cambridge welfare economist would describe it, the policy conclusions are still wrong. As the man himself said, “*the world of zero transaction costs, to which the Coase Theorem applies, is the world of modern economic analysis*” (Coase 1988: 15).

With this in mind, the Coase Theorem is a novel, insightful critique of the supposed state of welfare economics in the 1960s (I have no idea if his argument applies to the welfare economics of today). Unfortunately, the economics profession either didn’t pick up on this or took Coase’s theorem somewhere he didn’t want it to go. It’s why he said most discussion about his famous article and the Coase Theorem was “disappointing”. Unlike economists like George Stigler, Coase didn’t intend for his theorem to be an end in itself, but rather a stepping stone towards analyzing the economy with positive transaction costs:

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 Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances.

(Coase 1992: 9)

And as far as I know, mainstream microeconomics still hasn’t taken his suggestions to heart. The weird thing about Coase is that despite him being such an important economist, not many mainstream economists took his analysis seriously. His writings helped spawn a whole school of economic thought, but for the most part his influence on most of profession was somewhat marginal. It’s a damn shame.

*See this post by Frances Woolley for a more in depth explanation

References:

1. Canterbery, E. Ray, and A. Marvasti. “The Coase Theorem as a Negative Externality.” *Journal of Economic Issues* 4 (December 1992): 1179-1189.

2. Coase, R. H. *The Firm, the Market, and the Law*. Chicago: U of Chicago, 1988. Print.

3. Coase, R. H. “The Problem of Social Cost.” *Journal of Law and Economics* 3 (October 1960): 1-44.

4. Coase, R.H. “The Institutional Structure of Production.” *American Economic Review* 82 (September 1992): 713-719.

5. Madema, Steven G. “The Myth of Two Coases: What Coase Is Really Saying.”*Journal of Economic Issue* 28.1 (March 1994): 208-17.

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