The Washington Post completely mangles the Coase Theorem

Timothy B. Lee from the Washington Post surely seems like a nice enough guy, but he grossly distorts the Coase Theorem:

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. . . .

Sorry, Tim, but that is not what the Coase theorem says.  Coase, as he explained it to me when I was at Chicago, said that he only used the zero transaction cost example to illustrate the basic point.  It was just an example.  The real point here is that as long as the transaction costs are less than the gains from trade it doesn't matter who you give the property rights to.  If the transaction costs are greater than the gains from trade, it does matter who you give them to.  To argue that the Coase Theorem only applies in a cost free world is ridiculous.  I think that everyone argues that trade occurs when the gains from trade exceed the costs and that is the point that the Coase Theorem makes -- the cost of polluting or creating some other externality is the opportunity cost you lose from not engaging in these trades.

The point of the Coase theorem wasn't that markets would solve all externalities ("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"), but that there are a lot of transactions where the gains from trade are greater than the costs.  The point of the Coase Theorem was that it doesn't matter in terms of efficiency who you give the property rights to when the gains from trade are less than the costs, but that it does when transaction costs are greater and in that case you should allocate them to the higher cost avoider (e.g., in car accidents it is the car behind you in traffic that is liable). 

This was also the way that I was taught it in graduate school and way that anyone from Landes, Becker, Posner, Easterbrook, Peltzman, Stigler, Aaron Director, Milton Friedman, Demsetz, Alchian, etc. would explain it.  It seems to me that many critics of Coase set up a ridiculous straw man to attack because they can't otherwise criticize his basic point.

I would hope that Tim Lee will explain why the Coase Theorem only applies if transaction costs are zero.