To see how the Coase theorem works consider an example. Suppose that Dick owns a dog named Spot. Spot barks and disturbs Jane, Dick’s neighbor. Dick gets a benefit from owning the dog, but the dog confers a negative externality on Jane. Should Dick be forced to send Spot to the pound, or should Jane have to suffer sleepless nights because of Spot’s barking?
Consider first what outcome is socially efficient. A social planner considering the two alternatives would compare the benefits that Dick gets from the dog to the cost that Jane bears from the barking. If the benefits exceed the cost, it is efficient for Dick to keep the dog and for Jane to live with the barking. Yet if the cost exceeds the benefit then Dick should get rid of the dog.
According to the Coase theorem the private market will reach the efficient outcome on its own. How? Jane can simply offer to pay Dick to get rid of the dog. Dick will accept the deal if the amount of money Jane offers is greater than the benefit of keeping the dog.
By bargaining over the price, Dick and Jane can always reach the efficient outcome. For instance, suppose that Dick gets a $500 benefit from the dog and Jane bears an $ 800 cost from the barking. In this case Jane can offer Dick $600 to get rid of the dog, and Dick will gladly accept. Both parties are better off than they were before, and the efficient outcome is reached.
It is possible of course that Jane would not be willing to offer any price that Dick would accept. For instance, suppose that Dick gets a $1,000 benefit from the dog and Jane bears an $800 cost from the barking . In this case, Dick would turn down any offer below $1,000 while Jane would not offer any amount above $800. Therefore, Dick ends up keeping the dog. Given the costs and benefits, however this outcome is efficient.
So far, we have assumed that Dick has the legal right to keep a barking dog. In other words, we have assumed that Dick can keep Spot unless Jane pays him enough to induce him to give up the dog voluntarily. But how different would the outcome be if Jane had the legal right to peace and quiet?
According to the Coase theorem , the initial distribution of rights does not matter for the market’s ability to reach the efficient outcome. For instances, suppose that Jane can legally compel Dick to get rid of the dog. Although having this right works to Jane’s advantage, it probably will not change the outcome . In this case, Dick can offer to pay Jane to allow him to keep the dog. If the benefit of the dog to Dick exceeds the cost of the barking to Jane, then Dick and Jane will strike a a bargain in which Dick keeps the dog.
Although Dick and Jane can reach the efficient outcome regardless of how rights are initially distributed, the distribution of rights is not relevant: It determines the distribution of economic well being. Whether Dick has the right to a barking dog or Jane the right to peace and quiet determines who pays whom in the final bargain. But in either case, the two parties can bargain with each other and solve the externality problem. Dick ends up keeping the dog only if the benefit exceeds the cost.
To sum up:
The Coase theorem says that private economic actors can solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient.
Source: Principles of Economics.