R.H. Coase
The Problem of Social Cost
Journal of Law and Economics, 1960
Eva Herbolzheimer
University of Illinois at Urbana-Champaign
Background and Objective
 Some firm’s production process creates
negative effects (externalities) for other
firms or individuals
 Standard economic analysis at the time in
terms of divergence between private and
social product of a firm
Pigou “The Economics of Welfare”
 Firms are liable for the damage
 Tax equivalent to the damage (Pigovian Tax)
 Exclude firms from certain areas (zoning)
The Problem of Social Cost
The Reciprocal Nature of the Problem
 Traditional assumption obscures the nature of the choice
 Avoid the harm on B would inflict harm on A
 Ignores OPPORTUNITY COST
 Goal has to be to avoid the more serious harm
 Example: Cattle-raiser and Farmer
Problem: we have to know the value of what is obtained
and of what is sacrificed to obtain it
 in total and at the margin
The Problem of Social Cost
The Pricing System with Liability for Damage
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Assumptions:
Damaging Business has to pay for all damage caused
Pricing System works smoothly (=without cost)
Example: Cattle-raiser and Farmer
Cattle-raiser can put up a fence
Cattle-raiser can reduce his herd (= production)
Cattle-raiser can make a contract with farmer so the farmer
does not cultivate the strip of land
 Room for a mutually satisfactory bargain
 Agreement does not affect allocation of resources (only wealth)
The Problem of Social Cost
The Pricing System with NO Liability for Damage
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
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Assumptions:
Damaging Business does not have to pay damage caused
Pricing System works smoothly (=without cost)
Example: Cattle-raiser and Farmer
Farmer can put up a fence
Farmer can abandon production (or move to other place)
Farmer can pay the Cattle-raiser to reduce his herd (contract)
 Size of the herd will be the same
 Also room for a mutually satisfactory bargain
The Problem of Social Cost
Result
 The ultimate result (which maximizes production) is the same
for situations with or without liability, but only if the pricing
system is assumed to work without cost.
 There is always room for bargaining unless the marginal gain of
one firm is equal to the marginal loss of the other firm /
individual
The Problem of Social Cost
The system WITH transaction costs
 TC may make the perfect / optimal allocation impossible
 Possible ways to minimize TC
- Single ownership of property rights (Theory of the Firm)
- Contract (often long-term)
 Government Intervention (Super-Firm)
- Laws (Courts) / Regulation
- Institutions
BUT: Government Intervention might be more costly
 Economists and Policy-Makers overestimated advantages
The Problem of Social Cost
Critique of Pigou’s Analysis
 Pigou does not consider the cost imposed on the firm that
causes the damage
 Tax equal to the damage caused is not efficient
- High probability that there will be a better way to allocate
resources
- Impossible to measure effects of damage exactly
- Tax will not be distributed to those affected by the damage
- Tax will create wrong incetives
 Pigou had not thought his position through
The Problem of Social Cost
Coase’s Proposed Approach
 Taking into account Opportunity Cost
 Taking into account the difference between private and social
cost
 Instead of thinking of universal cases, starting analysis with a
model similar to the existing situation
 Thinking of factors of production as a “right” instead of a
physical product
 Easier to understand why sometimes it is desirable to
give a firm the right to do something that has a harmful
effect (socially justified)
The Problem of Social Cost
Summary of Coase Theorem
If property rights are clearly defined, then agents
can reach optimal allocation by bargaining
- Final allocation of resources will be independent from
allocation of liability for damage
- No government intervention is needed
- Allocation will be dependent on relative prices
The Problem of Social Cost
Interpretations of the Coase Theorem
 Efficiency Version:
“ Aside from transaction costs, the prevailing outcome
will be efficient.”
 Invariance Version:
“Aside from transaction costs, the same efficient
outcome will prevail.”
The Problem of Social Cost
Discussion
1) What do we care about more?
 The Size of the Pie
 The Distribution of the Pie
2) How do opinions regarding this question affect
policy and allocation of resources across the
globe?
The Problem of Social Cost