Ronald Coase, who died last week at the age of 102, was one of the greatest economists of the 20th century. His impact on academic thought and public policy is incalculable.

In 1991, Coase won the Nobel Memorial Prize in Economic Sciences in part for a theorem he set out in a 1960 article that is, by a large margin, the most cited law-journal paper of all time. The Coase theorem produced a revolution in both thought and public policy.

His target was the great British economist Arthur Cecil Pigou, who contended that if a polluter is emitting smoke, and thus causing injury, the best response is to make the factory owner pay for the injury or to impose a corrective tax.

Coase said Pigou failed to see “the reciprocal nature of the problem.” Suppose that a very noisy factory is causing legal injury to a doctor operating next door. Under Pigou’s approach, the factory should be required to pay damages to the doctor. But Coase pointed out that we could also make the doctor bear the cost. His central insight was that if people can bargain with one another, and if it isn’t costly for them to do so, it just doesn’t matter who is required to pay: People will negotiate their way to the efficient solution. This is the Coase theorem in a nutshell.

Here’s the basic idea: Suppose that under the law, the factory has to pay damages to the doctor. If the doctor can avoid injury by moving his office a few blocks away, and if he can do that cheaply, the factory will pay him to move, and that’s what he’ll do.

Now suppose that under the law, the doctor bears the cost. If he can avoid injury by moving his office a few blocks away, that’s what he’ll do. The legal rule won’t affect the outcome. The example is perfectly generalizable. The same analysis holds whenever people are harming each other (but are in a position to bargain).

Coase recognized, of course, that it will often be costly for people to negotiate with one another. If a factory emits pollution that affects thousands of people, a bargain is unlikely. Coase’s analysis suggests that when people can’t negotiate, policy makers should try to identify the agreement they would reach if they had been able to do so. To identify that agreement, they have to analyze the benefits and costs of the harm-producing activity. Coase emphasized that “all solutions have costs and there is no reason to suppose that government regulation is called for simply because the problem is not well handled by the market or the firm.”

Coase’s argument has a dramatic background. It was foreshadowed by a brief passage in an earlier essay he wrote on telecommunications. That passage caused much consternation in the University of Chicago economics department, whose members invited him to come to Chicago to discuss his “error” in person.

At the beginning of the session, the audience was essentially unanimous: Coase was wrong. Milton Friedman, a fierce debater and eventual Nobel Prize winner, led the charge against him. It was a clash of the titans, or perhaps an academic mugging: Coase stood alone.

As Coase told the tale, “I don’t know whether you’ve had a conversation with Milton Friedman, but an argument with Milton Friedman is a pretty strenuous affair.... But when at the end of whatever the time was ― say, an hour ― I found I was still standing, I knew I’d won. Because if Milton can’t knock you out in a few rounds, you’re home.” At the end of the evening, the group was again unanimous: Coase was right.

The Coase theorem has helped to spur market-oriented approaches in countless areas, including telecommunications (where auctions are in now widespread use) and environmental protection (where command-and-control approaches are often rejected in favor of systems that allow for trading).

Coase’s work has also helped reorient thinking about regulation in general, in part by emphasizing the importance of private flexibility, cost-benefit balancing, and careful, dogma-free empirical analysis (for which Coase made many pleas).

True, the theorem has run into some serious objections, including from behavioral economists and those who emphasize distributional considerations. But it continues to provide the starting point for inquiry into countless social problems.

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood,” John Maynard Keynes wrote. “Indeed, the world is ruled by little else.” In 1960, Chicago’s great economists were convinced that Ronald Coase was right. His ideas help to rule our world.

By Cass R. Sunstein

Cass R. Sunstein, the Robert Walmsley University professor at Harvard Law School, is a Bloomberg View columnist. He is the former administrator of the White House Office of Information and Regulatory Affairs, the co-author of “Nudge” and author of “Simpler: The Future of Government.” ― Ed.

(Bloomberg)