The most cited article in all of legal academics was written by Nobel Prize winning economist Ronald Coase. The article is called the problem of social cost and it includes what has become to be known as The Coase Theorem. The Coase Theorem holds that in a world without transaction costs, the choice of legal rules does not affect efficiency because private parties would always bargain their way to optimal behavior. Coase's famous example concerns the potential of railroad train sparks to cause fires to adjoining farmland. In the absence of bargaining, one would expect railroads to take more precautions, for example, by adding spark guards to their trains. If the law held railroads responsible for any fire damage losses to farmers crops. In contrast, in the absence of bargaining, one would expect farmers to take more precaution, for example, by planting their crops further away from the railroad tracks. If the law held that the farmers had to bear any fire damage losses that occurred to their own crops. Before Coase, lawmakers believed that in deciding whether to hold railroads liable for crop damages, the law would be influencing the amount of precaution taken by both railroads and by farmers. But by exploring a frictionless world of contracting where potential contractors without cost agree to all mutually beneficial transactions, Coase deduced that the law need not influenced precaution taking. In a world without transaction costs, the parties will have a mutual incentive to agree to have each expend the efficient level of precaution. In a world without transaction costs, if the law holds railroad strictly liable for all fire losses, the railroad will pay farmers to take the appropriate amount of precaution. In contrast, if the law holds railroads blameless for any crop losses then Coasean contracting will lead farmers to pay the railroad to take the efficient level of precaution. In a world of costless contracting, the choice among different legal standards for liability will not impact the levels of precaution taken by the railroads and by farmers. The legal standards will only impact the distribution of wealth as the background legal rules will often determine who pays whom. The theorem holds that in the absence of transaction costs, the assignment of legal rights will not impact the ultimate allocation of rights. This is sometimes referred to as the allocational invariance result because rights flow to their highest use. The Coase Theorem also holds that in the absence of transaction costs, the rights would be efficiently allocated. But again the assignment of rights will impact the distribution of income because if the most efficient owner is not initially assigned a right, he or she will have to pay for it. A huge and contested body of literature endlessly debates the circumstances under which the Coase Theorem predictions hold. Few scholars think that the conditions of costless contracting ever obtain. But just as the assumption of frictionless motion has proven to be a useful construct for physics, the assumption of frictionless contracting allowed Coase to analyze the effect of unimpeded bargaining in the shadow of the law. With unimpeded bargaining, different legal rules will not influence allocative efficiency. They'll only have distributional effects. The Coase Theorem has also interesting implications for contract law. Oliver Wendell Holmes Junior famously re-oriented contract law toward a dyadic conception of contractual duties. For Holmes, a contractual promise was not a sacred duty that simply had to be performed, rather a contractual promise was merely the duty either to perform or pay compensatory damages. But the Coase Theorem invites a triadic conception of promise. Following Coase, we might see a promise as a duty to perform, pay damages, or renegotiate your way out of performance. Imagine for example, that Holmes promised to paint Coase's picture for $1,000 in a bizarre jurisdiction that imposes property rule like damages that are 20 times the contract price. If Karl Bracey comes along and offers Coase $10,000 to paint Karl Bracey's picture, instead, the prospect of huge damages would normally deter Coase from breaching the initial contract. But the Coase Theorem suggests that Coase will have an incentive to approach Holmes and try to buy his way out of the Holmes' contract. The Coase Theorem suggests that we don't have to worry about too few breaches when damages are high because promises will bribe their way out of having to perform an inefficient promise. Can you see how a similar argument means we don't have to worry about too many breaches when damages are low? The Coase Theorem has even stronger implications with regard to the laws choice among different possible default rules. For example, in most jurisdictions, the default rule is at-will employment. This means that in the absence of contractual provisions to the contrary, an employer can fire an employee for good, bad, or no reason. Some commentators have proposed that a better default rule would be a just cause employment condition. Under a just cause default, an employer would promise not to fire an employee unless the employer had just cause. As applied to the choice among default rules, the Coase Theorem suggests that the law will impact neither allocative efficiency nor the distribution of wealth. In a world with costless contracting, the employer and employee will contract for the efficient level of protection that maximizes their joint gains regardless of the default rule. Regardless of the default rule, the parties will contract for the same salary.
