Rethinking Coase: What The Problem of Social CostReally Teaches Us

In the world of law and economics, few papers have had the lasting impact of Ronald Coase’s 1960 article The Problem of Social Cost. It’s a cornerstone of modern legal-economic analysis and, by some measures, the most frequently cited article in the entire field. Yet, for all its fame, it is also one of the most misunderstood.

Even Coase himself admitted that “my point of view has not in general commanded assent, nor has my argument, for the most part, been understood.” Decades of scholarship have focused almost exclusively on one part of his paper: what we now call the "Coase Theorem." But this obsession may have led us to overlook Coase’s real insights. It’s time we rethink what The Problem of Social Cost is truly about—and what that means for the intersection of law and economics.

The Coase Theorem: Powerful, But Misleading?

The most widely accepted version of the Coase Theorem goes something like this:

In the absence of transaction costs, it does not matter what the law is. Private parties can always negotiate costlessly to reallocate rights efficiently.

This idea has become the go-to summary of Coase's work in both law and economics. A review of the ten most-cited law review articles referring to Coase’s 1960 paper confirms this version as the dominant interpretation. But Coase was critical of this focus, stating that the discussion had "largely been devoted to sections III and IV of the article" and even there had "concentrated on the so-called ‘Coase Theorem,’ neglecting other aspects of the analysis.”

Why is that a problem? Because the theorem describes an idealized, frictionless world. Coase’s real interest lay in the messy, complex world we actually live in—a world filled with transaction costs, institutional constraints, and legal uncertainty. As he wrote elsewhere, one of his key critiques of Arthur Pigou (whose welfare economics dominated early 20th-century thinking) was that Pigou compared "a state of laissez-faire" with "some kind of ideal world." For Coase, theorizing in terms of perfection was not analysis—it was fantasy.

The Nobel Prize Clue: Looking at the Bigger Picture

To understand Coase's true contribution, we need to broaden our view beyond just one theorem. A useful starting point is Coase’s 1991 Nobel Prize, awarded "for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy."

The Nobel committee highlighted two papers: his 1937 essay The Nature of the Firm, where he introduced transaction costs as a way of explaining the existence of firms, and his 1960 work The Problem of Social Cost. While the former is celebrated for laying the groundwork of transaction cost economics, the latter is often misremembered only for its theorem.

Yet The Problem of Social Cost was never meant to be an abstract thought experiment. It was born out of Coase’s earlier work on the Federal Communications Commission. In that 1959 paper, Coase proposed that property rights and market mechanisms—not government regulation—could be used to allocate radio frequencies efficiently. The 1960 paper was, as he notes in footnote 1, a direct continuation of that earlier work. Colleagues at the University of Chicago urged him to generalize the insights from the FCC case to a broader set of problems—namely, externalities.

So Coase did just that. He used the concept of property rights to tackle the economic problem of externalities—what he called “social cost.” In doing so, he reframed the conversation from how governments should correct market failures to how legal rules structure the way people negotiate around them.

The Real Argument: Institutions Matter

Coase’s real argument is both more complex and more useful than the simplified theorem. It’s this:

The allocation of resources depends critically on the institutional structure—especially the legal system and the presence of transaction costs.

In other words, it does matter what the law is. Legal rules determine who bears the burden of transaction costs, who has the incentive to negotiate, and whether negotiation is even feasible. Coase’s goal wasn’t to dismiss the role of law, but to emphasize its foundational importance in shaping economic outcomes.

That’s the central thesis lawyers and economists often miss. The so-called Coase Theorem works in a world without transaction costs. But in our world—where those costs are everywhere—institutions like the legal system play a defining role.

Why This Misunderstanding Matters for Lawyers

If legal scholars and courts continue to treat the Coase Theorem as Coase’s main point, we risk drawing misguided conclusions about the role of law. More importantly, it exposes a deeper issue: the legal field lacks a consistent, rigorous framework for engaging with economic reasoning.

Without such a framework, legal-economic analysis becomes subjective and speaker-dependent—essentially rhetorical rather than analytical. That’s incompatible with the high standards of legal argumentation. We need to move beyond “law and economics” as a set of slogans or metaphors and toward a more disciplined, institutional understanding of how law interacts with economic activity.

Toward a Better Understanding of Coase

To truly honor Coase’s legacy, we must move past the catchy, oversimplified version of his work and engage with the full depth of his analysis. His central insight wasn’t about how people behave in a perfect world—it was about how institutions shape behavior in the real one.

That means acknowledging the centrality of transaction costs, the importance of legal rules, and the role of property rights not just as legal entitlements but as tools for structuring economic activity. Only then can we develop the kind of analytical framework needed for serious, objective legal-economic reasoning.

In short, the real Coasean question isn’t “What happens when transaction costs disappear?” It’s: “What happens when they don’t?” And that, more than any theorem, is the question worth answering.