Coase argued that if we lived in a world without
transaction costs, people would bargain with one another to produce the most efficient distribution of resources, regardless of the initial allocation. This is superior to allocation through litigation. Coase used the example of a
nuisance case named
Sturges v Bridgman, where a noisy sweetmaker and a quiet doctor were neighbours and went to court to see who should have to move. Coase said that regardless of whether the judge ruled that the sweetmaker had to stop using his machinery, or that the doctor had to put up with it, they could strike a mutually beneficial
bargain about who moves that reaches the same outcome of productive activity. However, many welfare-maximizing reallocations are often forgone because of the transaction costs involved in bargaining. For instance, the sweetmaker may have many neighbors who claim "nuisance" — some legitimate and some not, that the firm would have to sort through, and some of those neighbors who do claim nuisance may try to hold out for excessive compensation. In these cases, the transaction costs eat away, and ultimately eclipse, the price signals that would have led to the most efficient distribution of resources. In cases like these with potentially high transaction costs, the law ought to produce an outcome similar to what would result if the transaction costs were eliminated. However, there is no cost-effective method of determining precisely what that outcome would be, by definition. So Coase argues that the courts should only intervene in cases that cause an unreasonable amount of nuisance after a wide analysis with regard to the total effect of such interventions. Under this framework, the wall-builder is not legally liable for the nuisance suffered by his neighbor alone. In this example, Coase seeks to illuminate the conditions for optimizing the allocation of rights, the case in which both parties consider harmful. Here, Coase is referencing
Pareto efficiency allowed by the prevailing “pricing system”. Coase used the example of
pollution (raised by
George Stigler in The Theory of Price, 1952) several times: he argued that
arbitrage between actors in a market with low transaction costs could lead to an efficient market solution. Coase extends this framework throughout his development of a functional theorem concerning externalities. Coase argues that these rights are integrated into an actor's decision-making process through their unique cost function. These costs are not isolated in nature, according to Coase, who concluded “The cost of exercising a right (of using a factor of production) is always the loss which is suffered elsewhere” The ultimate thesis is that law and regulation are not as important or effective at helping people as lawyers and government planners believe. Coase and others like him wanted a change of approach, to put the burden of proof for positive effects on a government that was intervening in the market, by analysing the costs of the action. The argument forms the basis of the
Coase Theorem as labeled by
George Stigler. ==Theoretical challenges==