Mr. Pigou drew an important distinction between the private and social value of economic activities, such as the opening of a new railway line. The savings in time and effort that users of the railway enjoy are private benefits, which will be reflected in the prices they are willing to pay for tickets. Similarly, the railroad's expenditures on tracks, rolling stock, employee wages are private costs, which will help to determine the prices it charges. But the opening of the railway may also create costs for "people not directly concerned, through, say, uncompensated damage done to surrounding woods by sparks from railway engines," Mr. Pigou pointed out.It was this idea that gave rise to what George Stigler famously called the "Coase Theorem". What Coase was trying to point out was that Pigou's taxes and subsidies were not need within the framework - perfect competition, which assumes zero transaction costs - that Pigou himself assumed. As Stigler put it
Such social costs—modern economists call them "externalities"—don't enter the calculations of the railroads or its customers, but in tallying up the ultimate worth of any economic activity, "[a]ll such effects must be included," Mr. Pigou insisted. In focusing exclusively on private costs and private benefits, the traditional defense of the free market misses out on a vital element of reality.
To correct the problems that spillovers created, Mr. Pigou advocated government intervention. Where the social value of an activity was lower than its private value, as in the case of a railroad setting ablaze the surrounding woodland, the authorities should introduce "extraordinary restraints" in the form of user taxes, he said. Conversely, some activities have a social value that exceeds their private value. The providers of recreational parks, street lamps, and other "public goods" have difficulty charging people to use them, which means the free market may fail to ensure their adequate supply. To rectify this shortcoming, Mr. Pigou advocated "extraordinary encouragements" in the form of government subsidies.
The Coase Theorem thus assets that under perfect competition private and social costs will be equal.Given this equality, there is no need for any taxes or subsidies. This is not to say that such taxes/subsidies are not useful within a positive transaction cost framework, this, as Coase noted, would have to be decided on a case-by-case basis.