The Problem of Social Cost

A 1960s academic paper by Ronald Harry Coase, “The Problem of Social Cost,” re-imagines how to solve the problem of nuisances and disputes without always resorting to litigation. The paper entirely changed how much importance both lawmakers and public officials placed on law and regulation for deciding the outcome of any dispute, and it forms the backbone of modern legal economics. Coase wrote the paper while he was a faculty member at the University of Virginia. He received the Nobel Memorial Prize in Economic Sciences in 1991.

The paper covers what is known as the economic problem with externalities. Externalities are the costs or benefits that affect someone who did not ask for these costs of benefits. Naturally, legal costs, or the costs of litigation, often fall into this category. The law aims to justify these costs by making the person who is at “fault” responsible for most of them.
However, this cost apportioning is not always economically efficient, which is the thesis of the paper. Coase argues that we should eliminate transaction costs. He argues that parties should barter with each other to apportion expenses, leading to a fairer allocation than letting the courts decide.

Coase challenges the traditional economic approach to externalities, also known as Pigou’s Approach. The example often cited is that if a plant (X) causes $100 damage in pollution every year, the law should tax it $100 per year until it is fixed. If the plant can install a product to clear the pollution at a cost of, say, $90, the tax penalty will stop.



Coase claims that there is a major social problem with this approach. He claims that if X (the plant), gives out pollution harming Y (the local community), then making X pay $100 to the community each year allows Y to benefit by damaging X. The tax penalty each year has not solved the problem. It has simply created another one.

Instead, Coase proposes an alternative solution. This involves looking at what is economically efficient for everyone, which doesn’t always follow what the law states. For example, if it is cheaper for X to pay for Y to move away, instead of paying $100 in tax per annum, then Y should be moved somewhere else. This might cost X $40, not $100. By taxing X $100 every year, X is effectively paying more than the $100 of pollution damage it has caused.

The purpose of finding an alternative solution is to internalize, rather than externalize, the costs. Coase argues that this is always fairer. Once the parties agree between themselves what the fairest solution is, the costs are typically very low. However, when the parties litigate the issue, the costs skyrocket. Lawyers must determine who has what rights, how they can be enforced, and a whole host of other issues. Internalizing costs at the outset is fairer and more efficient for everyone involved.



The problem, Coase explains, lies in the difference between social and private costs. How these costs are apportioned is often unfair. In the above example, the unintended social cost is the damage to the community, i.e. pollution. The law typically forces the party at fault to cover these costs. Coase suggests we need to entirely reimagine the benefits of the polluting activities as weighed against its downsides.

Coase argues, for example, that if the pollution damages fish in a stream, we are forced to decide if the damage is worth the result. Is polluting the stream and killing the fish worth the power generated by the plant? That is what we must consider, as private individuals, because the law cannot answer such questions.
Coase acknowledges that litigation is sometimes necessary. In these circumstances, lawyers must consider how to minimize costs, because there are ways to do so. For example, lawyers can combine their firms and resources to neutralize costs, thus limiting the economic damage they are doing to each other in the marketplace.

Ultimately, both courts and legal professionals should be guided by the most economically efficient solution. In complex litigated disputes that often involve many separate claims, the transaction costs alone often make the whole process a waste of time. For example, in a nuisance claim, parties argue about property rights, and negligence, and damages, and a host of other issues. It is a long, convoluted process simply to arrive at the same result that the parties could have arrived at themselves.



In an example such as the one above, if the courts must decide on the issue and apportion costs, then they should always consider what the economically fair solution is. Often, this is not what the hard letter of the law says it should be. Economical considerations and marketplaces change, unlike the law, and courts should be adaptable enough to make the law work for the current market.