The genesis of the problem of social cost
The study of property rights and institutions has vividly engaged the attention of economists, philosophers and lawyers alike. Private property is often explained as the unavoidable byproduct of scarcity in a world where common-pool losses outweigh the sum of contracting costs and enforcement of exclusive property rights.
At the turn of the twentieth century, the underlying assumption in the economic literature was that private property emerged out of a spontaneous evolutionary process because of the desirable features of private property regimes in the creation of incentives for constrained optimization.This understanding of the relationship between scarcity and the emergence of legal entitlements characterized mainstream property rights theory when Coase entered the academic world as an undergraduate student in economics.19
Property rights theory at the London School of Economics
In the early 1930s, while Coase was conducting his undergraduate studies in commerce at the London School of Economics (LSE), one of Coase’s teachers, Sir Arnold Plant, was re-examining the theme of property rights from a novel perspective.20 In Plant’s view, the traditional justification for private property, scarcity, was incapable of serving as the sole intellectual foundation for this institution. In those years, Plant completed two papers on issues of intellectual property and copyright laws, showing that issues of incentives, rather than scarcity, were at the core of the property rights problem.21
There is, indeed, a striking correspondence of methodology and thematic between the later works of Coase and those of his undergraduate teacher. Both the focus on the incentive structure of legal rules, and the analysis of the effect of alternative laws on the final allocation of human and physical resources, reveal a remarkable affinity of technique, and the explicit use of legal rules as an object of economic research makes the comparison even more telling.22
It is indeed this fortunate combination of methodology and subject matter that would prove so valuable in Coase’s research.
Coase acknowledges the importance of his encounter with Plant at LSE, and pinpoints that ‘great stroke of luck’ as the origin of his interest in property rights theory.23 For Coase, the encounter with Plant was a true revelation. Plant’s repeated teaching that ‘[t]he normal economic system works itself’,24 and his belief that prices in a competitive market lead resources to their highest valuing uses, provided Coase with a powerful insight on the dynamic of the economic system:I was then 21 years of age, and the sun never ceased to shine. I could never have imagined that these ideas would become some 60 years later a major justification for the award of a Nobel Prize. And it is a strange experience to be praised in my eighties for work I did in my twenties.25
The experience of the following years in conjunction with the London School of Economics laid the methodological foundations of what would later become Coase’s theorem on the problem of social costs.
The University of Virginia years: the birth of an ingenious idea
All the ingredients of Coase’s revolutionary analysis on the debated theme of social cost had been profiled during his LSE years.26 But it is not until the late 1950s that Coase verbalizes such a simple - and yet ingenious - idea. He had first expounded the core of his later theorem in an article published in 1959 - a fact not always remembered in the bibliographic citations.27 In those pages, one grasps what would later become the underlying theme of Coase’s celebrated argument:
Whether a newly discovered cave belongs to the man who discovered it, the man on whose land the entrance to the cave is located, or the man who owns the surface under which the cave is situated is no doubt dependent on the law of property. But the law merely determines the person with whom it is necessary to make a contract to obtain the use of the cave. Whether the cave is used for storing bank records, as a natural gas reservoir, or for growing mushrooms depends, not on the law of property, but on whether the bank, the natural gas corporation, or the mushroom concern will pay the most in order to be able to use the cave.28
The discussion of the rationale of property rights under Coase’s highest- bidder framework obviously contained an attack on the Pigouvian approach to the problem.29 The point was rather self-evident to Coase, but not so for some of the Chicago economists.
George Stigler was among Coase’s early critics:Ronald Coase criticized Pigou’s theory rather casually, in the course of a masterly analysis of the regulatory philosophy underlying the Federal Communication Commission’s work. Chicago economists could not understand how so fine an economist as Coase would make so obvious a mistake. Since he persisted, we invited Coase (he was then at the University of Virginia) to come and give a talk on it. Some twenty economists from Chicago and Ronald Coase assembled one evening at the home of Aaron Director.... In the course of two hours of argument the vote went from twenty against and one for Coase to twenty-one for Coase. What an exhilarating event!30
According to Coase, the objections that were raised to his Federal Communication Commission (FCC) paper were the basis of his later 1960 article on the problem of social costs.31 In the course of his meeting with the Chicago economists, Coase had occasion to refine some of the arguments that he had outlined in his earlier work, arguments that he was later asked to put together in the form of an article for the Journal of Law and Economics.32 He entitled this paper ‘The problem of social cost’.
The Coase theorem
Coase’s 1960 article was soon to be recognized as a milestone in legal and economic literature - a milestone later characterized as the Coase theorem. In the course of his austere discussion, Coase does not reveal any sign of anticipated realization of the revolutionary power of his insight. Indeed, he insists that he never intended to convey his thoughts in the precise and analytical form of a theorem.33
A few years after the publication of ‘The problem of social cost’, a sizeable number of commentaries and theoretical elaborations were developed on Coase’s newly presented theme.34 The unpretentious style of Coase’s article had thus been crowned by a notoriety rarely attained by legal writings of any sort.35 Part of the uproar is explained by the fact that the article challenged an established principle of public finance.36 Before ‘The problem of social cost’, very little attention had been given to the possibility that the problem of externalities could be resolved through free market exchanges.37 In this way, the thesis advanced by Coase resulted in a rather revolutionary statement, one at the core of a central theme of economic science.38
Coase boldly attacks the conclusions reached by the Pigouvian tradition:
It is strange that a doctrine as faulty as that developed by Pigou should have been so influential, although part of its success has probably been due to the lack of clarity in the exposition. Not being clear, it was never clearly wrong....
I propose to show the inadequacy of this Pigouvian tradition by demonstrating that both the analysis and the policy conclusions which it supports are incorrect.39Coase contrasts the Pigouvian approach by demonstrating that, in the absence of transaction costs, generators of externalities and victims will negotiate to an efficient allocation of resources, independent of the initial assignment of rights among them.40 In confuting the conclusions of the Pigouvian tradition, Coase gives life to a model with much broader potential, a revolutionary new perspective for the evaluation of an unlimited number of legal and social issues.
Stigler, in 1966, was the first scholar to restate Coase’s model in the form of a theorem: ‘under perfect competition private and social costs will be equal’.41 In 1967, Alchian Demsetz defined the theorem in the following terms:
There are two striking implications of this process that are true in a world of zero transaction costs. The output mix that results when the exchange of property rights is allowed is efficient and the mix is independent of who is assigned ownership (except that different wealth distributions may result in different demands).42
Soon thereafter, Guido Calabresi stated the same principle more descriptively: ‘Thus, if one assumes rationality, no transaction costs, and no legal impediments to bargaining, all misallocations of resources would be fully cured in the market by bargains’.43
The implicit premise of Coase’s analysis draws upon a fundamental postulate of microeconomic theory: the free exchange of goods in the market moves goods towards their optimal allocation, such that, when every possibility of beneficial exchange is satisfied, resources will reach their optimal allocation according to the criterion of Pareto efficiency.44
The law creates many subjective juridical positions that are also susceptible to exchange and transfer.
Coase, applying by analogy45 the proposition of the free exchange of goods in the market, maintains that the transferability of rights in a free economy leads towards their best use and to a Pareto-efficient final allocation.46 The voluntary transfer of individual rights in the marketplace, thus, will cure a non-optimal allocation of legal entitlements.47The Coasean methodological revolution
Coase’s article, discussing widely cherished themes in the legal and economic traditions, constitutes, according to many commentators, the first example of an economic analysis of law in North American literature. The novelty of his approach inspired an entire generation of scholars - pioneers in this new branch of applied economics. In 1991, 30 years after the publication of ‘The problem of social cost’, Coase received the Alfred Nobel Memorial Prize in Economic Science. Through the prestige of this award, recognition came at last to honour the tradition of economic analysis of law that Coase so authoritatively represents. Only a few months prior to the award, Coase was recognized, together with Calabresi, Henry G. Manne and Richard A. Posner, as a founding father of law and economics.48 This late recognition follows many years of challenging debate. Many of the writings that developed around ‘The problem of social cost’ tested the premises of Coase’s model, seeking to undermine its operative conditions. The corollary literature, which was almost unanimous in acknowledging the theoretical soundness of Coase’s approach, often stressed the lack of practical reach of his analysis.
Acknowledging the risk of an inaccurate first impression, it is possible to observe that the various criticisms pertained to three fundamental points, relating to the operative possibilities and practical effects of Coase’s model. One group of critics observed that the Coase theorem disregarded the interindustrial long-term effects of the system.49 These critics argued that Coase utilized tools of static analysis, disregarding the possible disequilibria which may occur subsequent to the negotiation, and that the conclusions reached by Coase needed to be tested in light of the dynamic changes in the initial equilibrium.
A second group of critics concentrated, instead, on the distributional effects of the model.50 According to their criticism, to affirm that, in the absence of transaction costs, the final allocation of resources will be efficient in no way implied - much less guaranteed - the absence of transfers of wealth induced by the changed legal rule. Further, these critics observe that, even disregarding the distributional effects of the rule, a different assignment of the right could in some cases create the conditions for strategic behaviour in negotiation capable of disturbing the efficiency of the final allocation.51 A third group of authors focused on the scarce realism of the no-transaction cost assumption.52 According to this criticism, the true Achilles’ heel of Coase’s analysis was in the unrealistic assumption of absence of costs in the process of negotiation and transfer of the right. Many commentators observed that in order to obtain the efficient operation of Coase’s model, it was not enough to eliminate legal impediments to the free transferability of individual rights; it was necessary as well to operate in an imaginary world with no costs involved in the negotiation or transfer of the right. These authors observed that the idea of a transaction without cost is a logical fiction rather than a real possibility, and that by unveiling such a fiction, the theorem remains a mere tautology.The following sections will discuss in greater detail the significance of these criticisms, and the impact that the emerging debate has had on the traditional approach to legal interpretation.