The Coase Theorem

Introduction

When do legal rules matter for efficiency? This chapter presents and discusses the Coase Theorem (1960), which is one of the most important and remarkable findings in economics. The theorem states that under certain conditions legal rules will have no bearing on the economic efficiency of resource allocation. As long as there is some legal rule in place, then an efficient outcome will ensue.

The Coase Theorem lays the foundation for the entire field of law and economics, because it shows the conditions under which legal rules will matter for economic efficiency, and hence the conditions under which the basic principles of cost-benefit analysis can be brought to bear in the analysis and assessment of the economic consequences of legal rules. The analysis in this chapter will allow us to examine in detail the economic issues involved in the Coase Theorem, and the theorem's implications.

Coase recognised that standard approaches to externalities - which begin from the premise that harm is 'caused' by one party - neglect the fact that when one individual takes costly actions to reduce harm, the other party gains at his expense. The fact that 'harm' can be reduced by taking costly actions which benefit another illustrates the reciprocal nature of externalities. This is not surprising, since social costs really are just that: social.

The chapter is structured as follows. Sections 3.2, 3.3 and 3.4 use the Edgeworth Box to present the Coase Theorem. Section 3.5 explores the role of transaction costs in the Coase Theorem and examines two kinds of transaction costs: lump-sum costs and per unit costs. Section 3.6 examines whether the Coase Theorem holds when there are more than two parties, and introduces tools from cooperative game theory to address this question.

 
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