The "Coase theorem," in one respect, is a triumph of social science scholarship. Web searches using "Coase theorem" as key words typically yield over 100,000 hits. Economists, legal scholars, environmentalists, and political scientists have written volumes on the theorem. Few ideas written by economists in the 20th century have been as widely debated. And the debating continues, 47 years after the publication of "The Problem of Social Cost" (Coase 1960), the essay recognized as the source of the ideas in question. There is only one problem: Ronald Coase maintains that the theorem that bears his name conveys an idea that is antithetical to the message that he intended.
My view is that virtually all of the criticism of the Coase theorem fails to appreciate the actual message that Coase intended with "Social Cost" and is, therefore, essentially irrelevant. Tragically, because we have focused on what he was not saying, we have not grasped what he was saying. Consequently we have been neither sufficiently appreciative nor sufficiently critical of his actual message.
Coase on the Problem of Social Cost
With the publication of The Firm, the Market and the Law (Coase 1988), a collection of essays which republished "The Problem of Social Cost" and "The Nature of the Finn" and which also included insightful reflections on the legacies of those articles, Coase (1988) broke his protracted silence on the way in which his work had been interpreted by economists, legal scholars, and other social scientists. He contends, "My point of view has not in general commanded assent, nor has my argument, for the most part, been understood." He attributes this lack of understanding to the fact that "most economists have a different way of looking at economic problems and do not share my conception of the nature of our subject" (Coase 1988: 1). Among his specific points of departure from the mainstream, he holds the view that economists' preoccupation with studying the logic of optimal choice has caused them to neglect the study of the institutional setting in which choice takes place and that this has eroded the substance of economic research, that human action cannot be adequately characterized as a constrained optimization problem, and that modern economic theory ignores the role of transaction costs (Coase 1988: 3-7).
Perhaps the most revealing statement that Coase (1988: 13) makes about the theorem that bears his name is the following:
"The Problem of Social Cost" ... has been widely discussed in the
economics literature. But its influence on economic analysis has
been less beneficial than I had hoped. The discussion has largely
been devoted to sections III and IV of the article and even here
the discussion has concentrated on the so-called "Coase theorem,"
neglecting other aspects of the analysis. In sections III and IV, I
examined what would happen in a world in which transaction costs
were assumed to be zero. My aim in doing so was not to describe
what life would be like in such a world but to provide a simple
setting in which to develop the analysis and, what was even more
important, to make clear the fundamental role which transaction
costs do, and should, play in the fashioning of the institutions
which make up the economic system.
Coase goes on to explain that a world without transaction costs is a peculiar world in which, among other things, firms would not exist (Coase 1988: 14-15). In fact, economic institutions, according to Coase, do not matter in a world without transaction costs.
Many critics of Coase have focused their attack on his apparent neglect of the existence of transaction costs in the real world. But this criticism is misplaced. Coase's discussion of the peculiar unreal world with no transaction costs was intended to draw out the strange implications of perfect competition, which he viewed as the central perspective in modern economic analysis. …