Teaching the Coase Theorem: Are We Getting It Right?

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A small but growing number of economists, including Ronald Coase himself, argue that Coase's approach to externality problems is misrepresented by standard formulations of the Coase theorem [Coase, 1988; 1994; Friedman, 1991; McCloskey, 1998; Medema, 1994; 1995; Medema and Samuels, 1997; Posner, 1993; Klaes, 2000]. Despite the fact that Coase's ideas are discussed in virtually every undergraduate microeconomics textbook, Coase et al. believe, "to a considerable extent, what is taught in the textbooks is the (externality) theory as it existed before Coase" [Friedman, 1991]. The aim of this paper is to investigate this claim: to identify the distinctive features of Coase's externality analysis; to survey current introductory and intermediate microeconomics texts to determine whether and to what degree they get it wrong, and, in conclusion, to consider the implications of these findings for economic education.

Coase's Two-Stage Argument in the "Problem of Social Cost"

Coase's aim in "The Problem of Social Cost" [1960] was to criticize the modern theory of negative externalities by "exposing the weaknesses of A. C. Pigou's analysis of the divergence between private and social products" [Coase, 1994, p. 10]. (1) Pigou's Economics of Welfare [1960 (1932)] inspired a generation of economists to see taxes and regulations as the best way to promote economic efficiency in the presence of spillover costs. Coase attacks this analysis on a number of levels, beginning with Pigou's definition of the problem. Pigou defines a negative externality as a perpetrator or victim situation in which one party is causally and legally liable. Coase argues however, that such problems are inherently reciprocal, arising from incompatible interactions between two parties rather than the harmful actions of one upon the other. "If we are to discuss the problem in terms of causation, both parties cause the damage" [Coase, 1960, p. 13]. From this perspective it is better to "forget about causation and si mply ask which party to a harmful interaction should be induced to change his behavior (maybe both should be) to maximize the social product" [Posner, 1993, p. 201]. In Coase's words [1960, p. 2]:

The traditional approach has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm.

Coase examines this problem under the standard assumptions of perfect competition, including zero transaction costs. (2) He is careful to pose this not as a "Coase theory of externalities" but simply as a logical restatement of Pigou's approach [1960, p. 2]. Under these ideal circumstances Coase shows that negative externalities are fully self-correcting; private bargaining yields an efficient (re)allocation of rights. Further, he shows that this efficient solution will emerge regardless of which party bears the legal burden of accommodation. Using his classic example of the farmer and the cattle-raiser, Coase shows that it does not matter for efficiency whether the damaging agent (the cattle-raiser) is held liable for the damage caused [1960, pg. 2-8]. "The ultimate result (which maximizes the value of production) is independent of the legal position if the pricing system is assumed to work without cost" [1960, p. 8].

Coase then presents a second stage of analysis entitled "The Cost of Market Transactions Taken Into Account" [1960, p. 15]. No minor addendum to the previous discussion, it occupies 2/3 of the paper and is the only part for which Coase claims originality [Coase 1994, p. 9]. His aim here is to show that "[o]nce the costs of carrying out market transactions are taken into account. …