Coase Theorem

Zero Transaction Costs

Coase argued that traditional analysis is directed at solving the wrong problem with respect to externalities. Under the traditional approach, if a factory billowing fumes imposes damages on neighboring homeowners, the analysis is directed at how best to restrain the factory's fumes. Coase argued that the analysis is misdirected because any action aimed at avoiding harm to homeowners necessarily inflicts harm on the owners of the factory. The correct question, in Coase's view, is how to avoid the more serious harm.

Underlying Coase's argument is the view that, in terms of the cold logic of economic analysis, the cause of an externality cannot be attributable to any single party. In almost all cases, the externality is a joint product of decisions made by economic agents. For example, a factory billowing smoke may be a nuisance to the homeowners living downwind. Coase argued that, in the economist's view of causality, the externality would not exist without both the factory producing smoke and the homeowners desiring to breathe clean air. Coase observed that the economic analysis of an externality stands apart from the legal analysis of determining, based on a notion of fairness, who is a victim and who is liable for causing damages.

Coase argued that the notion of economic efficiency under the traditional approach was incomplete because it took for granted the outcome of the legal process. Coase argued that, within the limits of the traditional approach, an efficient solution is produced only if the party assigned liability happens to be the one who can avoid the problem at the lower cost. The approach is incomplete, in Coase's view, because it fails to account for the fact that in a smoothly operating market (i.e., one without transaction costs), economic agents are free to buy and sell rights. If the law assigns the right initially to the wrong person, the person to whom the right is of the most value can still buy it. The Coase theorem states this thesis.

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