The Coase Theorem was first proposed by Noble laureate Ronald H. Coase. In an article entitled The Problem of Social Cost, Coase sought to analyze how legal and economic systems organize resources to allocate goods and services. He recognized that legal systems were, in many instances, structuring the rights and responsibilities of firms in a way that led to inefficiency, by limiting their ability to use resources more efficiently. He saw the root of the problem in the allocation of property rights, with suboptimal results stemming from a failure to fully internalize the cost of externalities (in the form of loss of production) onto the firms responsible for them.

The Coase Theorem states that if there are no transaction costs, parties will be able to negotiate an economically efficient outcome, regardless of the initial allocation of the property rights. Under the theorem, if parties can freely bargain and negotiate over their respective claims to a given property, an optimal outcome can always be achieved. Proponents of the Coase Theorem argue that when parties are given the chance to negotiate, economic theory suggests that each party will reach an arrangement which makes them both better off. If parties are allowed to freely negotiate, economic efficiency will be maximized, no matter who initially holds the property rights.

In practice, however, transaction costs mean that parties cannot negotiate easily, and that given limited time, parties may not calculate all possible costs before entering into a contract. This means that the real effect of the Coase Theorem is to set the legal conditions that encourage parties to, at the least, partially internalize the costs of any conflicts, externalities, or negative externalities created by their decision. The Coase Theorem encourages parties to pursue some form of internalization and negotiation of costs, because any externalization of costs will result in a less than optimal outcome. By arguing that parties should be internally rational, Coase is attempting to encourage efficiency and achieving an optimal outcome.

The Coase Theorem is an important tool that can be used to understand the functioning of economic systems, especially when market and legal structures are involved in allocating or settling disputes over scarce resources. While the conditions for the Coase Theorem to apply perfectly may not be met in the real world, creating legal conditions that encourage efficient negotiation of costs can produce the best outcome. In the end, the Coase Theorem is an argument that legal systems should incentivize parties to find an efficient solution to disputes, so resources are allocated in the most beneficial manner for society.