Nobel Laureate Ronald Coase died last month at the age of 102. I’m sure that most readers of this blog have never heard of Ronald Coase, and I’m equally sure that most of the few who have heard of him likely forgot his name less than an hour after completing their microeconomics exam. Coase was one of the founders of the Law and Economics movement, the goal of which is to encourage more economic analysis when crafting legal rules. As a law student whose pre-law graduate work was primarily in economics, I have a lot of respect for Coase and feel the need to spread his legacy to a wider audience.

Coase’s most notable contribution to economic theory was in the analysis of externalities, an economic concept I will attempt to briefly explain. Markets are essentially social price-setting mechanisms, and when everything is working well, a market will set a price that balances the costs of producing a good with the benefits of consuming that good. This, in turn, ensures an economically efficient distribution of resources. However, markets can only do that when all the costs and benefits are factored into the transaction. Sometimes, costs and benefits of the transaction are external to market participants. The classic example of a negative externality is pollution. If a factory can dump its waste in a nearby stream for free, the management doesn’t account for the effects of this water pollution when deciding its prices. Thus, because the market price of the factory’s goods does not factor in the very real social cost of production, there will be inefficient overproduction by the factory, while the public who bears the cost of the water pollution go uncompensated.

Before Coase, the standard economic solution to this problem was to impose a suitably high tax so that the producer would internalize the external costs. Either the producer would modify its behavior to account for the true cost of production, or it would provide a revenue stream to compensate the victims of the negative externality. Coase, however, turned the traditional analysis on its head by noting that the real problem here is that the different parties both want to use the same resource for different purposes.

Coase gave the example of a doctor and a confectioner who have adjacent offices. During the day when the doctor is trying to see patients, the confectioner uses machinery that makes loud noises and causes vibrations sufficient to disturb the doctor next door. Coase said the problem is not that there is a social cost imposed by the confectioner that must be taxed away, but rather that both the doctor and the confectioner want to use the same space for their two businesses in ways that are incompatible. It is true that the confectioner is disturbing the doctor’s practice with his noise. However, it is equally true that the doctor’s practice is disturbed by the noise only because it’s located next to the confectioner.

Coase’s real genius was in his solution to this problem. Under Coase’s analysis, the parties themselves can negotiate an economically efficient solution without any outside help. Let’s say that, in our example, the doctor has the right to force the confectioner to stop running the machinery and making the noise. The confectioner can instead offer to pay the doctor to move to a new office. If the confectioner derives greater economic value from the location than the doctor does, they should be able to come to a mutually agreeable price that will get the doctor to agree to move. If, however, the doctor derives greater economic value from the location, no price the confectioner is willing to pay will be enough to convince the doctor to leave, so the confectioner will have to find a new place to ply his trade. In either case, the solution is economically efficient because the externality is resolved while the party who derives the greater economic value gets to stay. The exact same analysis would apply, only in reverse, if the confectioner had the right to make as much noise as he wanted and the doctor attempted to pay the confectioner to move.

Unfortunately, Coase’s elegant solution, which is called the Coase theorem, only works if there are well defined property rights (e.g., either the doctor has a clear right to stop the confectioner’s noise or the confection has a clear right to make noise) and if there are relatively low transaction costs (e.g., there are only a few parties, all of whom are willing to negotiate in good faith). This doesn’t happen as often with real life externalities as we would like. Nonetheless, it’s a great example of how a simple change in perspective can suggest a new solution to an old problem that is revolutionary in its time, only to become common sense a generation or two later. In my book, that is a legacy worth remembering.