In 1960 Ronald H. Coase, who won the Nobel Prize in Economics in 1991, published his paper The Problem of Social Cost. It presents the Coase Theorem as a new perspective on external effects, particularly harmful effects. Coase formulated his theorem as follows: "With costless market transactions, the decision of the courts concerning liability for damage would be without effect on the allocation of resources" (1960, p. 10). This theorem floors Arthur Pigou’s welfare-economic approach of externalities. Since the publication of Pigou’s The Economics of Welfare (1920) economists were used to seeing externalities (side effects) as divergences between private and social net products. In this respect, the conventional thought is that if A inflicts harm on B, A should be restrained. The harm is a (social) cost to B, not having been taken account of in A’s private-cost-benefit calculation. Governmental interventions such as taxes remedy this private-social-product divergence, as a prerequisite for economically efficient decisions in the market place. This is the Pigovian approach.
The case of Sturges v. Bridgman, used by Coase, may illustrate the Pigovian approach, and shows that the Pigovian route runs into serious problems: For many years, a confectioner has had some machinery in operation on his premises. A doctor then occupies neighboring premises. After some years, the doctor builds a consulting room right next to the room containing the confectioner’s machinery. The vibration and noise produced by the confectioner’s machinery makes the doctor’s use of the consulting room impossible, resulting in an income loss of, say, $100. The doctor goes to court and the court orders the confectioner to refrain from using his machinery. This judgment matches the Pigovian line of thought. The confectioner’s production decision did not take the doctor’s (social) costs into account. At the same time, the sentence makes clear that considering the problem in terms of private and social products ignores the reciprocal nature. Suppression of the confectioner’s harm to the doctor inevitably harms the confectioner. It might be that the sentence harms the confectioner for more than $100. In that case, it is inefficient to ban the confectioner’s business. The social net product is less than it might be.
Coase’s perspective on the problem of social cost is "to avoid the more serious harm" (Coase 1959, p. 26).
Coase formulated this starting point of his theorem in a paper preceding the "Social Cost" paper. In his paper, "The Federal Communications Commission" (1959), Coase wondered why etheric scarcity requires government regulation, whereas for other scarce means such as capital, labor, and land the American economic system uses the price mechanism. Coase identified that it is the absence of property rights in radio frequencies that blocks the use of the pricing system. Well-defined property rights for frequencies will lead to wave trade, allocating a frequency to the highest bidder. "Chaos disappears; and so does the government except that a legal system to define property rights and to arbitrate disputes is, of course, necessary" (p. 14).
In his "Social Cost" paper Coase elaborated this property-rights perspective. Referring to the Sturges v. Bridgman case, the liability sentence affects the property rights concerning the neighboring premises, and foremost defines these property rights. The confectioner’s liability will induce him to indemnify the doctor if his business brings him an income higher than the doctor’s harm of $100. Similarly, the confectioner will move his machinery if this option costs less than $100. On the other hand, if the sentence had been that the doctor had no right to stop the confectioner’s business, the doctor might pay the removal option, if priced at less than $100. Property rights bring about trade when mutual benefits are present. It must be said that the cost of transaction may hinder a beneficial deal. However, the Coase Theorem claims that market transactions allocate property rights to the highest bidder provided that transaction cost is zero.
Coase regretted that the zero-transaction-cost-world assumption of the theorem, in which "people can negotiate their way to efficiency" (Farrell 1987, p. 113), has received so much emphasis in the economics literature. People certainly do not live in such a world. Therefore, the most compelling message of the Coase Theorem is to take into account positive transaction cost in fashioning social arrangements. Key variable transaction cost should urge lawyers and legislators to identify in what manner the social net products might be increased. An elaboration of the Coase Theorem is the creation of air-polluting-emis-sion rights. These rights induce polluters to seek emission-reduction alternatives, opening options to sell the rights profitably to the highest bidder.