Legal Theory Lexicon 002: The Coase Theorem

This is the second installment in the Legal Theory Lexicon, an experimental Sunday feature of Legal Theory Blog primarily aimed at law students. Each week I introduce a basic concept or idea in legal theory. This week the idea is 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).
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 locamotives cast off sparks that cause a fire that damages Farmer Jones's crop, imposing a cost on Jones of $100. That ocst 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.
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! If we assume zero transaction costs, then when there are externalities, the market will reach the efficient outcome irrespective of how entitlements are assigned. Another mouthful! Let's go back to our hypo:
Assuming zero transaction costs, it doesn't matter whether the law assigns the right to generate sparks to the railroad or the right to be free from sparks to the farmer. Why not? Let's work it out. There are two possibilities:
If we assign the entitlement to the farmer, the railroad will pay $100 in damages to the farmer for vioalting the farmer's right to be spark free. The railroad will realize that it can save this $100 cost by investing $50 in a spark arrestor. So the railroad will buy the spark arrestor.
If we assign the entitlement to the railroad, the farmer will incur $100 in costs from the fire. The farmer will realize that he can save this $100 cost by entering into a contract whereby he pays $50 (plus some extra enducement, say $51 total) to the railroad in exchange for the railroad installing the spark arrestor. Since we have assumed zero transaction costs, the railroad and the farmer both benefit from this deal.
That's it! It doesn't matter whether we assign the right to the farmer or the railroad. Either way, we get the efficient outcome.
If you are a first year law student, the Coase theorem is a very powerful analytic tool for understanding the economics of tort law. When you study a new rule or problem, ask yourself, "How would this come out assuming zero transaction costs?" Then ask, "If we assume positive transaction costs, how does the problem change?"
One word of warning, the zero-transaction-costs assumption is just an assumption. In the real world, there are always (or almost always) transaction costs. Nonetheless, in some situations, transactions costs are sufficiently low so that the efficient bargain can be struck. In other situations, this is not the case. That's where the action is!
Links
The World According to Coase
The Coase Theorem: A Study in Economic Epistemology by Gary North
Bill Edmundson's Handout on the Coase Theorem