AI at Your Side: Coase, Property Rights, and the Emergence of Institutional Economics and Law and Economics

A rancher raises cattle beside a farmer’s fields. From time to time the cattle stray across the boundary and trample the crops. The larger the herd, the greater the farmer’s losses.

Ask almost anyone what should be done, and the answer is immediate: the rancher caused the damage, so restrain the rancher. The familiar remedies follow—a fence, a tax, or liability requiring the rancher to compensate the farmer.

Ronald Coase’s 1960 paper, The Problem of Social Cost, challenged its intuition. It became one of the most cited papers in economics. It introduced what later became known as the Coase Theorem—a name Coase himself never accepted—and helped launch both law and economics and the new institutional economics. Yet most textbooks present it as a clever solution to externalities. That reading misses its central insight. The paper is fundamentally about legal institutions and the costs of defining, enforcing, and transferring rights.

This is the fourth piece in a series that reads one classic paper at a time with AI at your side, alongside the book I wrote with Raul A. Sosa, AI at Your Side: The Student’s Guide to Smarter Learning, forthcoming from Oxford University Press. The place to start is the argument Coase was writing against.

The externality and the Pigouvian tax

Consider the rancher’s decision one steer at a time. Each additional steer costs a little more to raise than the previous one because the best pasture is used first, and each causes $100 of damage to the farmer’s crops. The rancher bears the first cost but not the second. That unpaid cost is the externality.

Table 1. Each steer does $100 of damage the rancher never pays for. Society bears both costs.

Suppose a steer sells for $300. The rancher adds steers as long as the next one costs him up to $300 to raise, so he keeps five. From society’s perspective, the cost is the rancher’s production cost plus the crop damage, and by that measure only three steers are worth raising. The fourth destroys $50 of social value and the fifth destroys $100. The private herd is five, the socially efficient herd is three, and the $150 of destroyed value is what economists call a deadweight loss.

Figure 1. The rancher stops where his own cost meets the $300 price: five steers. Society would stop at three. The shaded gap is the deadweight loss, $150.

The standard cure comes from Arthur Pigou, and it is the one economists have traditionally reached for first: tax the rancher $100 per steer, the amount of the damage. The tax folds the farmer’s loss into the rancher’s own cost, and he stops at three on his own. The tax does not distort the market. It removes a distortion that was already there. For forty years this was the answer to an externality: measure the gap between private and social cost, and tax it away. One policy tool for one objective, as Jan Tinbergen taught.

Asking an AI what an externality is returns a definition you already knew. Handing it the table and making it work through the numbers is a different exercise.

Prompt: “Here is a cost schedule for a rancher whose steers damage a neighbor’s crops [paste Table 1]. A steer sells for $300. Find how many steers he raises on his own and how many are efficient for society. Show the steer-by-steer comparison, compute the deadweight loss, and tell me in one sentence why the gap between his cost and society’s cost is exactly $100.”

The response (generated using Claude):

The rancher looks only at his own cost: $100, $150, $200, $250, $300. The fifth steer, at $300, is his last; a sixth would cost $350. He keeps five. Add the $100 damage and a steer costs society $100 more, so the third is the last one worth raising and the efficient herd is three. The waste is $50 on the fourth steer and $100 on the fifth, a $150 deadweight loss. The $100 gap between his cost and society’s is exactly the damage he never pays: erase it, and the two herds become one.

The point of the exercise is not the answer, which you already have. It is to check whether the machine reasons the way you would: whether it sums the two steps of the loss, $50 plus $100, instead of giving one blended number, and whether it connects the gap to the damage. The checking is where the learning happens.

Coase’s argument

Pigou’s analysis treats the rancher as the cause of the harm and the farmer as its victim. Coase rejects this framing. The harm, he argues, is reciprocal: restraining the cattle protects the farmer’s crops, but it also reduces the rancher’s production of meat. “The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm.” The choice is between meat and crops, and calling the rancher the culprit does not say which is worth more.

From that reframing Coase derives the result. Suppose the two can talk, a court has assigned the right clearly, and reaching and enforcing a deal cost nothing. Then the herd ends at three steers no matter who holds the right. If the rancher is liable, he pays $100 per steer in damages, faces the full social cost, and stops at three. If he is not liable, the farmer pays him to shrink the herd. The fifth steer sells for $300 and costs $300 to raise, so it earns the rancher nothing. The fourth costs $250, so it earns him only $50. Each does $100 of damage, so the farmer gladly pays the rancher to give both up, and the trading stops where the rancher’s profit on a steer equals the damage it does. Either way, three steers.

That is the Coase Theorem as the world came to state it: when rights are clear and bargaining and enforcement is costless, the allocation of resources, here the size of the herd, does not depend on who holds the rights. Coase shows it with the same cattle example. Such agreements, he writes, “would not affect the allocation of resources but would merely alter the distribution of income and wealth.” The assignment of the right determines who pays whom, not how many steers get raised.

The theorem is best understood by taking the costless bargaining away. Ask the AI to redo the problem with a friction.

Prompt: “Confirm the herd is three under both liability rules, and say who pays whom in each. Then add a friction: reaching a deal costs $200, more than the $150 the efficient herd would save. Redo both rules. In which does the herd fall to three, and in which does it stay at five?”

The response (generated using Claude):

With free bargaining the herd is three either way. Under liability the rancher pays the farmer; under no liability the farmer pays the rancher. Now add the $200. Under liability the rancher owes for damage whether or not they ever negotiate, so he still cuts to three. Under no liability the only fix is a deal worth $150 that costs $200, so no one makes it, and the herd stays at five. The right the rancher started with now decides the outcome.

The important difference between the two cases is this. Under liability, no bargain is required, so transaction costs never become relevant. Under no liability the efficient outcome requires a deal that costs more than it saves, so the deal is never struck. When bargaining and enforcement are free, the assignment of the right changes only the direction of payment. When it is costly, it changes what gets produced. That cost of striking and enforcing a deal is what economists call a transaction cost.

Stigler and the name

The Chicago economists were initially skeptical of the result. Coase had first advanced it in a 1959 article on how the government allocates radio frequencies, and Aaron Director invited him to dinner at his home so that the Chicago economists could show him he was mistaken. About twenty economists came, Milton Friedman and George Stigler among them. Coase asked the room to assume a world without transaction costs and to accept that, in such a world, the assignment of liability would not affect the allocation of resources. Stigler recalled the evening in his memoirs: Friedman “did most of the talking, as usual,” and over two hours of argument “the vote went from twenty against and one for Coase to twenty-one for Coase.” It was Stigler who later named the result the Coase Theorem. (Historian Steven Medema notes that no vote was actually taken. The tally was Stigler’s dramatization, though Coase agreed it captured the spirit of the evening.)

Coase never accepted the theorem as a statement of his contribution. The frictionless world of zero transaction costs was a device for exposing Pigou’s framework, not a description of any actual economy. He made the point years later, in The Firm, the Market, and the Law: “The world of zero transaction costs has often been described as a Coasian world. Nothing could be further from the truth. It is the world of modern economic theory, one which I was hoping to persuade economists to leave.”

Property rights, transaction costs, and the legal system

The contribution, then, is not a solution to externalities. It is a different way of thinking about what determines economic efficiency.

Transaction costs are never zero. Defining and enforcing legal rights is costly, and when those costs are high, efficient bargains are never struck. Then, as Coase wrote, “the initial delimitation of legal rights does have an effect on the efficiency with which the economic system operates.” An economy is a system of rights: to use land, to emit smoke, to make noise, to be free of it. Producing anything requires combining rights, and combining rights requires transacting. The more it costs to define a right, to find its owner, to transfer it, and to enforce it, the more beneficial trades never happen. The efficiency of an economy depends crucially on the transaction costs its property-rights system generates. That observation is the starting point of the new institutional economics. It is also why much of the paper reviews English court cases about smoke, noise, and straying animals. When transacting is costly, a judge who decides who holds which right is deciding how resources will be used.

It also explains why clear property rights alone do not solve the externality problem. When transaction costs are low, a bad assignment gets corrected by bargaining, as the rancher and the farmer showed. When transaction costs are high, no bargaining will fix a bad assignment, and the resources stay where the law put them. The legal system therefore matters in two ways. First, it determines the level of transaction costs through the clarity of rights and the cost of enforcing them. Second, where bargaining cannot work at all, the initial assignment becomes the final allocation, so courts and legislatures should try to assign rights where they do the least damage.

Spain provides a striking example. The Crown gave the Mesta, the guild of migratory shepherds, legal rights of passage and pasture across the farmland of Castile. It was the rancher and the farmer again, now at the scale of a kingdom. Millions of farmers and herders could not bargain with one another, so the allocation of land was determined by the initial assignment of rights. Economists still debate whether those privileges built Spain’s advantage in wool or held back its agriculture (Drelichman, 2009). But no one debates that the law, good or bad, governed the use of the land the whole time.

Staying for the moment with Coase’s two-party case, the implication is not that Pigou’s logic was always incorrect. When transaction costs are zero, the tax is unnecessary: the two parties bargain their way to the efficient outcome. When transaction costs prevent that bargain, however, a Pigouvian tax may improve the allocation. But the tax must then be judged like every other institutional arrangement, by comparing its costs with its benefits.

Coase gives a concrete example. A factory’s smoke does $100 of damage a year. The factory can eliminate the smoke with a device that costs $90 a year, while the neighbors can avoid the harm by adjusting on their side for $40 a year. The cheapest solution is the neighbors’ $40 one. But under a $100 tax, the factory buys the $90 device, since $90 beats $100, and the neighbors, who no longer suffer any smoke, do nothing. Society spends $90 where $40 would have done, because the tax puts all the pressure on the factory and none on the neighbors.

The tax also demands a lot from the government. Setting it correctly means measuring the full loss the smoke imposes on everyone affected, information Coase was “unable to imagine” anyone collecting. Running a tax system is itself expensive. The government must administer it, and the taxes it raises and the spending it finances distort other decisions in the economy, so removing one loss creates others. None of this makes taxes useless. It makes them one institutional arrangement among several, alongside private bargains, direct regulation, and, sometimes, doing nothing. The government’s “administrative machine,” Coase warned, “is not itself costless.” “All solutions have costs,” he concluded, and the right question is which arrangement produces the most value in the actual world, not in a frictionless one.

The problem becomes more complex when many parties are involved. Coase’s examples have two neighbors, and later work showed that even costless bargaining can fail with three or more. Whatever two of them agree to pay the third, the third can always offer one of them a better private deal, and the three-way agreement collapses (Aivazian and Callen, 1981). In practice, the failure is even more pronounced: a polluted river involves a large number of parties, and the cost of bringing them to one table is enormous. Those are precisely the cases where bargaining breaks down and institutional design—the laws and organizations that define and enforce rights—does all the work.

Three extensions

Three important implications follow from Coase’s central idea. The first is Coase’s own earlier paper, The Nature of the Firm (1937), written when he was in his twenties. If markets coordinate the economy as well as the textbooks say, why is so much production organized inside firms, where a manager gives orders and no prices are used? Firms are, in a phrase Coase took from D. H. Robertson, “islands of conscious power in this ocean of unconscious co-operation.” Coase’s answer is that using the market is costly. “There is a cost of using the price mechanism”: you must find out what things cost and write a contract for every deal. A firm replaces many small bargains, whose enforcement is not costless, with one standing arrangement. A firm stops growing when doing one more task inside the organization costs as much as buying it from the market or, in Coase’s words, when “the costs of organising an extra transaction within the firm are equal to the costs involved in carrying out the transaction in the open market.” That condition still tells economists where the boundary of the firm lies: what a company does itself and what it buys from others. The 1991 Nobel Prize cited the 1937 and 1960 papers together.

The second extension is political economy. Daron Acemoglu (2003) asked why societies do not bargain their way to efficient institutions the way Coase’s neighbors bargain to the efficient herd. His answer is commitment. “Underlying the Coase theorem is the ability to write enforceable contracts.” In Acemoglu’s words, those who hold power “cannot commit to not using their power to renege on their promises,” so the deals that would deliver better institutions cannot be trusted and are never made. In Coase’s terms, the costs of enforcing those deals are prohibitive. Inefficient institutions survive because the groups that would have to give up power cannot be promised compensation for doing so.

The third extension is international. Coase’s insight applies whenever rights are difficult to define and enforce. This is true not only for private disputes but also for political and international ones. Within a country, the state acts as a third-party enforcer of rights. Internationally, there is no sovereign above states, and great powers often settle questions of property and security through power rather than law. Institutional economics largely assumes states that enforce contracts at home and a rules-based international order abroad. Yet that international order often lacks a de jure enforcer. That missing enforcer is one of the field’s blind spots.

Coase in the age of AI

The costs of transacting are precisely what AI is now reducing. Drafting a contract, monitoring compliance: each is a task these systems already perform. As the cost of using the market falls, the boundary of the firm shifts, and work that was kept inside a company because contracting it out was too costly can move to the market.

Lower transaction costs do not, however, resolve the question of who owns the rights. When a self-driving car injures a pedestrian, or a model is trained on disputed data, the question is the one Coase posed in 1960: the harm is reciprocal, and the task is to assign a clear right and enforce it. This is the argument I made in Let Coase Drive Us Home: what will limit the adoption of AI is not the technology itself but the institutions that govern it—the definition and enforcement of rights over data, decisions, and liability. Nor do the commitment problem in politics or the absence of an enforcer between nations disappear simply because technology improves. The bottleneck for AI will be institutional, not computational.

The worst way to read Coase today is to ask an AI to explain the Coase Theorem. The answer will be the familiar frictionless interpretation, the very reading Coase spent thirty years correcting. The better way is the one this essay has illustrated: build the example, work the bargain under both rules, add a transaction cost, add a third player. AI can help, but only as a sparring partner. That is the habit of mind this series is trying to cultivate.

Exercises

1. Reconstruction (no AI). Explain, in your own words, why Coase thinks “how do we restrain the rancher?” is the wrong question. What does the reciprocal nature of the problem mean, and how does it change what the law should aim for?

2. Invariance by hand (no AI). Using Table 1 and a $300 steer, show that the herd is three under both liability rules, and work out who pays whom in each. State in one sentence what is invariant across the two regimes and what changes.

3. Compare the arrangements (AI). Give an AI the smoke example: $100 of annual damage, a $90 prevention device for the factory, and a $40 adjustment available to the neighbors. Ask it to compare a $100 tax on the factory, a clear assignment of rights with costless bargaining, and costly bargaining. Which arrangement minimizes social cost, and why does the tax choose the wrong solution in this case?

4. Break the bargaining (AI). Have an AI build the simplest example of three parties who would all gain from an agreement, but where every proposed deal can be undone by a side deal between two of them. Then ask what this implies for externalities that involve millions of parties.

5. The political theorem (AI). Ask an AI why societies do not simply adopt efficient institutions, then rebut its answer using Acemoglu’s commitment problem: a bargain no one can be forced to keep is not a bargain.

6. Coase on a machine (AI). Choose one current issue—liability when a self-driving car injures a pedestrian or ownership of a model’s training data—and analyze it as Coase would. Identify the reciprocal harm, the parties, the right in dispute, the transaction costs, and where enforcement breaks down.

References

Daron Acemoglu (2003). “Why Not a Political Coase Theorem? Social Conflict, Commitment, and Politics.” Journal of Comparative Economics 31(4): 620–652.

Varouj A. Aivazian and Jeffrey L. Callen (1981). “The Coase Theorem and the Empty Core.” Journal of Law and Economics 24(1): 175–181.

Ronald H. Coase (1937). “The Nature of the Firm.” Economica 4(16): 386–405.

Ronald H. Coase (1960). “The Problem of Social Cost.” Journal of Law and Economics 3: 1–44.

Ronald H. Coase (1988). The Firm, the Market, and the Law. University of Chicago Press.

Mauricio Drelichman (2009). “License to Till: The Privileges of the Spanish Mesta as a Case of Second-Best Institutions.” Explorations in Economic History 46(2): 220–240.

Sebastian Galiani and Gustavo Torrens (2025). “The Economic Approach to Geopolitics.” Journal of Economic Behavior & Organization 237.

Steven G. Medema (2020). “The Coase Theorem at Sixty.” Journal of Economic Literature 58(4): 1045–1128.

Arthur C. Pigou (1920). The Economics of Welfare. Macmillan.

George J. Stigler (1988). Memoirs of an Unregulated Economist. Basic Books.

Sebastian Galiani and Raul A. Sosa (forthcoming). AI at Your Side: The Student’s Guide to Smarter Learning. Oxford University Press.

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*** Disclaimer: I used ChatGPT-5.5. as an editorial and language-refinement tool. The ideas and arguments are entirely my own, and I take full responsibility for them.