Transaction Costs and the Law

Despite Ronald Coase’s many contributions to economics, he is most famous for the co-called Coase Theorem, which is just one small part of his paper The Problem of Social Cost. Simply put, in a world of sufficiently low transaction costs, property rights, institutions, and the law don’t matter. If rights are assigned randomly, the result will always tend toward an efficient outcome: deterrence of a problem will fall upon whoever is the low-cost avoider. When transaction costs are high, however, then the assignment of rights absolutely does matter. Conflicts arise because of the interaction between two (or more) parties and thus, even if one party is “wrong,” they may not be the best to assign the duty to reform. As Coase himself explains:

The conclusions to which this kind of analysis seems to have led most economists is [sic] that it would be desirable to make the owner of the factory liable for the damage caused to those injured by the smoke, or alternatively, to place a tax on the factory owner varying with the amount of smoke produced and equivalent in money terms to the damage it would cause, or finally, to exclude the factory from residential districts (and presumably from other areas in which the emission of smoke would have harmful effects on others). It is my contention that the suggested courses of action are inappropriate, in that they lead to results which are not necessarily, or even usually, desirable.

Judges seem to be aware of the fact that assignment of rights matters significantly in a high transaction cost environment, at least in a de facto sense. Whenever a conflict arises between two parties, judges often push for a settlement: let the parties hash out among themselves what a desirable solution is. Judges seem to little want to be placed in a position where they must force a decision. (Of course, one could say that judges just want to reduce their workload as much as possible, and that is why they push for settlement. That’s likely the primary reason; judges are overworked. But the point remains: the judges are acting as if they value economic efficiency).

However, sometimes transaction costs (which include negotiation costs) do not allow for a settlement to come easily. One major way is that both parties, in a dispute, may be quite upset with one another. As George Mason University professor John Schuler and I pointed out in our 2019 Econlib article Have Coase – Will Travel,* anger, sadness, disappointment, etc., all make negotiation difficult; they are, indeed, transaction costs. Judges have limited means to reduce these transaction costs.

One method that has arisen over the past few decades to reduce transaction costs is mediation. Mediation is a private process, conducted under the shadow of law, to try and resolve conflict. Judges may suggest mediation or the process may be voluntarily sought by the parties. Either way, mediators seek to create a settlement by facilitating negotiation with both parties.

Mediators differ from judges insofar as they are not necessarily legal experts. They have no authority to bind parties. They have no authority to impose sanctions or outcomes. Further, they are active in the negotiation process: they can talk to the parties, try to convey the feelings of others, encourage parties to get creative in problem-solving, etc. In a sense, they are a therapist as much as anything.

The mediation process has arisen as a means to reduce transaction costs and reach mutually beneficial solutions. In that sense, they are very Coaseian. Just like other middlemen, they reduce transaction costs and seek to make the legal process more efficient.

Many common law scholars, from Richard Posner to modern times, argue that one of the virtues of the common law is that it tends toward economic efficiency. The emergence of mediation as a means to reduce negotiation-related transaction costs is additional evidence of that point.

*For a discussion on how to use this in the classroom, see Have Coase – Will Travel: New Ways to Teach Coase Using Old Media by Jon Murphy, John Schuler, and Jadrian Wooten (2020). Journal of Private Enterprise 25 (4), 71-86.