The Coase theorem is a way to deal with the tragedy of the commons problem surrounding common resources such as the environment. Ronald Coase is an economist who won a Nobel Prize for Economics and developed his theory in 1960. The coast theorem is a market-based solution to the negative externality created by pollution. The theory suggests that property rights are not essential and that government intervention is not necessary but rather, if parties can negotiate (without incurring excess cost) to correct a negative externality then the problem can be solved.
Coase's theory states that if the actions of party A harms party B, then party B can create an incentive for party A to reduce or stop the action creating the harm. In short, one can bribe another to stop a harmful action. To be clear, this theorem assumes that the cost of bargaining is very low or none at all. This assumption breaks down in situations were there is unequal political or social power between party A and party B, see social license for further discussion of this.
For example, there is a coal fired power plant that produces electricity and it was built before a small town developed nearby. As the town developed, they became aware that the winds blew the pollution released from the plant into the town. One way to correct for this negative by-product of electrical generation would to be for the town to pay the coal plant to install better air scrubbers, particulate matter collectors and other pollution control mechanisms in order to reduce the ill effects felt in the town. This move is said to be pareto improving because it makes at least one party better off without any other party being worse off as a result of the action. If the cost of the new measures is $40,000 and the town offers a higher amount then both parties will be better off as the town will have higher air quality and the coal plant will make some money.
Coase argues that property rights are much less of a factor. Consider the example above, assume that the company is given the right to pollute the air around the factory and town. The town could still pay the coal plant to reduce its level of pollution without having to re-allocate the property rights to the air.
Coase's theorem breaks down when the bargaining is expensive. If there's no ability to bargain, then an equitable solution can't be reached. In the example above the company may not be willing to talk with the people in the town without being forced to. Forcing the interaction will cost the town in legal fees. If the company is slow to act then the disadvantage of breathing the polluted air for that time period may not make it worthwhile for the town to pursue the negotiations. If the negotiations will take a very long time and due to legal and other fees cost more than $40,000 than, according to Coase, the endeavor is not worth pursuing. This means that transaction costs are the limiting factor for the Coase theorem. If dealing with the company directly is too expensive, then the town is further ahead changing the 'property rights' of the company to pollute the air.
In general though, whenever cost of dealing with the company is more expensive than the harm created bythe externality then trying to fix the problem isn't worth it.
Coase finds the pigouvian system of externality control to be "faulty". Coase argues that in setting up a market for pollution permits that firms can trade amongst themselves, the government can reach an efficient level of pollution without creating excess inefficiency in the market.
In this way firms can decide amongst themselves who can pollute the most and in certain cases, firms will be able to sell their permits for a profit thus improving the economic incentive to pollute less and sell more permits to other firms.