Economists study various problems referred to as "market failure" - situations that, at least potentially, justify government intervention to solve them. Externalities (or "social costs") are viewed as perhaps the greatest market failure problems. The externality issue has also occasioned much re-thinking of fundamental economic principles, particularly in the context of Ronald Coase's article on "The Problem of Social Cost." Coase explained that externalities manifested a more fundamental issue in economics, the costs of transacting over rights to affect other's welfare. Following Coase's work, economists almost reflexively consider social costs problematic only when transaction costs are relatively high. Yet, Coase's analysis has resulted in much confusion, even disagreement. For example, Harold Demsetz has recently objected to aspects of the Coase approach, as a matter of both economics and of government policy. As economics, Demsetz says, Coase's focus on transactions costs is not helpful in resolving questions concerning externalities. Even if transaction costs were zero, externalities would still exist. Moreover, Demsetz objects that focus on transaction costs to explain persistent externalities furnishes spurious reasons for undesirable government intervention in markets. This paper summarizes and evaluates Demsetz objections, maintaining that Demsetz sometimes ignores points that Coase has made. At the same time, Demsetz adds new insights to the Coase Theorem.

Date of this Version

January 2004