Economist Ronald Coase, a Nobel laureate from the University of Chicago, has proved that, in the absence of negotiation costs, the generator of an externality and the victim of it will negotiate to the same level of pollution regardless of how property rights to the environment are assigned.  (Coase, R.  1969.  The problem of social cost.  Journal of Law and Economics, Oct. 1969)

Although this seems counterintuitive at first, the Coase Theorem is fairly simple to explain. Consider the case of the paper mill upstream from the trout hatchery, discussed in the previous lecture.

Suppose the paper mill's marginal benefits of polluting the river are MB, and the hatchery's marginal pollution damage costs are MD. If the paper mill has a legal right to pollute the river, he could pollute to the point Q1, where MB = 0. But the trout hatchery owner, facing high marginal damages at Q1, could negotiate with (pay) the paper mill owner to reduce his pollution. The trout hatchery is willing to pay up to MD for pollution reduction, while the paper mill is willing to accept any payment over MB to reduce pollution. So the hatchery and paper mill would negotiate a reduction to Q*, where MB = MD. The hatchery's WTP represents an opportunity cost of pollution to the paper mill: each additional unit of pollution above Q* now costs the paper mill more in lost payments from the hatchery than it's worth.  In effect, the paper mill is now internalizing the costs of its pollution above Q₂  according to the hatchery's MD schedule. The marginal cost of pollution at Q* is $OC. The hatchery might pay the paper mill $OC for each unit of pollution reduction from Q₁ to Q*.

Now suppose instead that the hatchery has the legal right to a clean river. If the paper mill wants to function, it will have to negotiate with (pay) the hatchery to tolerate some level of pollution. The hatchery suffers no pollution damage below level Q₂, and would be willing to accept any minimal payment for pollution to that level. Above Q₂ the hatchery is willing to accept any payment over MD, while the paper mill is willing to pay up to its MB schedule for its pollution. The hatchery and paper mill negotiate an increase in pollution to Q*, where MB = MD. The pollution outcome is the same. Now the paper mill's WTP for pollution represents an opportunity cost of clean water to the hatchery. The marginal cost of pollution control at Q* is $OC. The paper mill might pay the hatchery $OC for each unit of pollution up to Q*.

In summary, the two parties will negotiate to the same level of pollution regardless of how the property rights are assigned.  The allocation of property rights merely determines who pays who.  This is an issue of equity, not efficiency.  If the conflict is resolved through litigation, the judge may think he is determining how much pollution should be allowed, but he isn't.  The court merely determines the entitlements, or who pays who, but whatever the decision, the negotiated level of pollution will be the same.

Coasian bargaining depends on the critical assumption that the ex ante entitlements (property rights) are well-defined and the transactions to reallocate these are costless. Coase emphasizes that high transactions costs may frustrate the attainment of Q* or any pollution level close to it.  In theory at least, the negotiation between polluter and victim will proceed as long as the transactions costs are less than the value of the surplus gain realized from the transfer of rights.  In the above example, there were only two parties, each negotiating for himself or herself. In reality, pollution externalities commonly involve many victims, and in some cases, many polluters.  In these cases, efficient negotiation requires that the victims and/or polluters cooperate.

A typical real-world pollution externality involves one or a few polluters and thousands of people affected by the pollution. In such cases, although the aggregate pollution damages may be substantial, no one person suffers enough personal damage to motivate him to action against the polluters. Negotiations are thus unlikely to occur if people view collective citizen action as a public good and wait to free-ride on someone else's initiative.  Likewise, Coasian bargaining will fail if negotiation involves high costs (legal fees, etc.--see "Economics of Litigation").

A long section of Coase's article discusses several court cases resolving externality conflicts where the litigants' rights were not clearly defined.  Coase suggests the court decision should maximize the "social product," and notes that many other legal considerations seem irrelevant to an economist.  In such cases, a "polluter pays" principle is at least a likely expedient to minimize transactions costs.

The latter part of Coase's article includes a critique of Pigou's theory of taxing polluters.  Coase is clear that a "polluter pays" solution, implemented as a pollution tax, may provide an economically efficient outcome, but the tax revenues should not be used for compensation of the victims, since this eliminates victims' incentives to reduce their exposure to the pollution, or might even attract new victims or motivate victims to increase their exposure.  Likewise, a Pigovian subsidy to polluters for reducing their emissions might simply attract more polluters.  On the other hand, another efficient, incentive-compatible solution  (though obviously less equitable) would be to tax the victims for exposing themselves to the pollutant!

Some theoreticians argue that the best solution to such problems is to simply clarify entitlements and responsibilities. Remember that externalities and public goods problems can be viewed as failures of the property rights system, where entitlements are either incompletely defined, or are not practically enforceable. Unfortunately, such clarifications must typically be pursued through the courts or legislature. Both venues are extremely costly.

See the lectures on the economics of litigation and public choice theory for expanded discussions of the inefficiencies of the courts and government in promoting social efficiency.