AN INTRODUCTION TO LAW AND ECONOMICS Fourth Edition ‘A. MITCHELL POLINSKY Josephine Scott Crocker Professor ‘of Law and Economics ‘Stanford University 2 Wolters Kluwer Law & Businessoe CHAPTER 3 THE COASE THEOREM ‘one of the central ideas in the economic analysis of law, ‘was develped im an article by Ronald H. Coase in 1960.” MMfis lies, which has since been named the Coase Theorem, se ise easily described by an example. Consider o factory 4s moe eke causes damage t0 the laundry hung outdoors Brave measby residents, In the absence of any comrective action pdt teeident would sulfer $75 in damages, a total of $379. The San damage can be eliminated in either of two ways:asmoke See ee carpe installed on the factory’s chimney, at @ cost Sf's150, of each resident can be provided an electric dryes ata eee Oe $50 per resident, The efficient solution is cleatly to Sel the smokescreen because it eliminates total damages st375 for an outlay of only $150, and itis cheaper than pur casing five dryers for $250 ‘Zero Transaction Costs ‘The question asked by Coase was whether the efficient ‘outcome world result if the Fight to clean air is assigned to the seeldents oF ifthe right to pollute is given co the factory H ahere isa right to clean air, then the factory has three choices: Pollue and pay $375 in damages, install a smokescreen for 3150, or purchase five dryers for the residents at a total cost ae ous0. Clearly, the factory would install the smokescreen, 7. Ronald H. Coase, The Problem of Social Cost, LL, & Eeon. 1 (1960)uw ‘An Induetin Law and Feononies the efficent solution. If there is aright to pollute, then the residents face thee choices: suffer their collective damages OF 8375, purchase five dryers for $250, or buy a smokescreen for the factory for $150. The residents also would purchase the smokescreen, In other words, the efficient outcome will be Uchieved regardless of the assignment of the legal right. Tova implicitly aseumed in the preceding paragraph that the residents could costlesly get together and negotiate with. the factory. In Coase’s language, this is referred to as the [sumption of zero transaction costs. In general, transaction costs include the costs of identifying the parties with whom ‘One has to bargain, the costs of getting together with them, the Coste of the bargaining process itself, and the costs of enforcing Sy bargain reached. With this general definition of transac: tion costs in mind, we can now state the simple version of the Coase Theorem:If there are 2ero transaction costs the effi- ‘Sent outcome will oceur regardless of the choice of legal rae, ‘Note that, although the choice ofthe legal rale does not affect the attainment of the efficient solution when there are ero transaction costs it does affect the distribution of income, ithe residents have the right toclean air, the factory pays $150 for the smokescreen, whereas ifthe factory has the right to pollute, the residents pay for the smokescreen. Thus, the Choice of the legal rule redistributes income by the amount bf the least-cost solution to the conflict. Because it is assumed for now that income can he costlessy redistributed, this dis: tributional effect is of no consequence —if itis not desired, it can be easily corrected Positive Transaction Costs “The assumption of zero transaction costs obviously is unre- alistic in many conflict situations. At the very leas, the disput {ng parties usually would have to spend time andfor money to set together to discuss the dispute. To see the consequences of ‘ositive transaction costs, suppose in the example that it costs tach resident $60 to get together with the others (due, say, tO {ransportation costs and the value of each resident's time}. Ifthe, i “The Coase Theoret 5 ee residents have a right to clean air, the factory again faces the ‘choice of paying damages, buying a smokescreen, or buying E five dryers, The actory again would purchase the smokescreen, the efficient solution. If the factory has a right to pollute, each resident now has to decide whether to bear the loss of $75, buy a f “ryer for $50, or get together with the other residents for $60 t0 collectively buya smokescreen for $150. Clearly, each resident Will choose to purchase « dryer, an inefficient outcome. Thus, given the transiction costs described, the right to clean air is ‘efficient, but the right to pollute is not. ‘Note that in the example the preferred legal rule mini ized the effects of transaction costs in the following sense. ‘Under the right to clean air, the factory had to decide whether to pay damages, install a smokescreen, or buy five dryers, Because it was not necessary for the factory to get together ‘with the residents to decide what todo, the transaction costs — the costs of the residents to get together —did not have any ‘fleet, Under the right to pollute, the residents had to decide what to do, Because the residents were induced to choose an inefficient solation in order to avoid the cost of getting together, the transaction costs did have an effect, Thus, even though no transaction costs were actually incurred under the right to pollute because the residents did not get together, the effects of taansaction costs were greater under that rule ‘We can now state the more complicated version of the ‘Coase Theorer If there are positive transaction costs, the efi tient outcome may not occu under every legal nue. In these circumstances, the preferred legal rule is the rule that mint imizes the effects of transaction costs. These effects include fctually incurring transaction costs as well as the inefficient thoiges induced by a desire to avoid transaction costs “The distributional consequences of legal rules are somewhat more complicated when there are transaction costs, It is fo longer true, a8 it was when there were zero transaction costs, that the choice of the rule redistributes income by the mount of the least-cost solution. In the example, ifthe res: dents have the right to clean ais, the factory pays $150 for the smokescreen, whereas ifthe factory has the right to pol lute, the residents pay $250 for five dryers6 ‘An Incoduction Law and Economics ‘Although the simple version ofthe Coase Theorem makes: an unrealistic assumption about transaction costs, it provides ‘useful way to begin thinking about legal problems because it suggests the kinds of transactions that would have to occur ‘under each legal rule in order for that rule tobe efficient. Once these requited tansactions are identified, ie may be apparent that, given more realistic assumptions about transaction costs, ‘one rule clearly is preferable to another on efficiency grounds. ‘The more complicated version ofthe Coase Theorem provides, 4 guide to choosing legal rules in this situation. All of the applications investigated in this book—including nuisance law, breach of contract, automobile accidents, pollution con- trol, products liability, and litigation —can be approached in this way, although some fit more naturally into the Coasian framework than others.