The Coase Theorem is widely cited in economics. Ronald Coase hated it.

There's a famous joke about a dairy farmer who, hoping to increase milk production, seeks the help of a theoretical physicist at the local university. After carefully studying the problem, the physicist tells the farmer, "I have a solution, but it only works if we assume a spherical cow."

(Courtesy of the University of Chicago Law School / Associated Press)

Nobel Prize-winning economist Ronald Coase died Monday at age 102. (Courtesy of the University of Chicago Law School / Associated Press)

Physicists frequently make simplified assumptions to help them understand the world. Masses are spherical, motion is frictionless, and surfaces are infinitely large. Everyone knows these assumptions are unrealistic, but they are necessary to tease out the fundamental principles that make the world work.

Economists do this, too. Economics is full of models where people only produce hot dogs and buns, where everyone is omniscient, or where economic actors live forever. One of the most famous of these simplified models is known as the Coase Theorem, named after Nobel Prize-winning economist Ronald Coase, who died Monday at age 102. Ironically, Coase came to dislike this "theorem" because it was co-opted by ideologues to justify conclusions that were roughly the opposite of those Coase himself intended.

The Coase Theorem says that in the absence of transaction costs — the costs of identifying potential trading partners, negotiating contracts, monitoring for compliance and so forth — it doesn't matter how property rights are allocated. For example, suppose the law gives a factory owner an unlimited right to pollute. If the pollution does the town's residents more harm than the value of what the factory produces, then the citizens will pool their funds (remember, we assumed this can be done without cost) and pay the factory owner to shut down his factory. Conversely, if the factory owner has to ask everyone for permission before polluting, then if the factory is economically beneficial he'll be able to cut a deal where he pays each resident for permission to continue polluting. Either way, the factory will only run if doing so is economically efficient.

Of course, that "no transaction cost" assumption is ridiculous. In the real world, it's not practical for millions of people to each pay a few dollars to convince a factory owner to shut down, or for the factory owner to send out millions of tiny checks each month. And that was the point of "The Problem of Social Cost," the essay that introduced the argument that was later dubbed the Coase Theorem. A world without transaction costs is the economist's version of a spherical cow. Coase's goal in describing a transaction-cost-free world was to focus attention on the importance of transaction costs to economic policy.

But the "Coase Theorem," a term coined by Coase's University of Chicago colleague George Stigler, took on a life of its own. Economic policy analysts on the political right began treating "zero transaction costs" not as a heroic simplifying assumption, but as a plausible policy goal. For example, one Heritage Foundation blogger invoked the Coase Theorem in 2010 as supporting the proposition that "the government has to define property rights and then get out of the way and trust the market."

Coase himself hated this. "I never liked the Coase Theorem," Coase said on the EconTalk podcast last year. "I don't like it because it's a proposition about a system in which there were no transaction costs. It's a system which couldn't exist. And therefore it's quite unimaginable."

Coase believed that high transaction costs sometimes justify government regulation. "There is no reason why, on occasion... governmental administrative regulation should not lead to an improvement in economic efficiency," Coase wrote. "This would seem particularly likely when, as is normally the case with the smoke nuisance, a large number of people are involved and in which therefore the costs of handling the problem through the market or the firm may be high."

Yet Coase argued that government regulation wasn't a panacea, either. "There is a further alternative, which is to do nothing about the problem at all," Coase wrote. "Given that the costs involved in solving the problem by regulations issued by the governmental administrative machine will often be heavy, it will no doubt be commonly the case that the gain which would come from regulating the actions which give rise to harmful effects will be less than the costs involved in Government regulation."

Of course, this subtle argument — that transaction costs can be an argument either for or against regulation — isn't pleasing to ideologues at either end of the political spectrum. Maybe that's why the vulgar interpretation of the Coase Theorem has become so much more widely known than the argument Coase actually made.

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