Coase's Bargaining Solution
There are two main approaches to solve the environmental externality:
a) Appropriate government policies, and
b) Well-defined property rights.
Government policies pertain to direct regulation (or, command and control approach), and market-based approach in the form of economic instruments. The property rights approach is applicable when either community or individual posses well defined property rights in carrying out the environment related activities. The property rights approach, developed by Ronald Coase in 1960, suggests that an efficient solution to the problem of externality may be arrived at if property rights are well-defined. This solution, popularly known as 'Coase theorem', states that efficient allocation of resources and solution to Pareto relevant externality is possible under the following assumptions:
i) Zero transaction costs - the cost involved in the bargaining process between the two parties do not exists,
ii) Well- defined property rights - either of the party or both the parties’ posses’ well-defined property rights
iii) Perfect competition prevails in the market,
iv) No income or wealth effects is imposed with the Coasean solution, and
v) No free rider effects -- since the parties have well defined property rights.
In this situation let us illustrate the method of bargaining for feasible solution through an example. Let us consider the case of a polluting factory which dumps its effluents to the nearby river as a result of which the water downstream gets polluted. The water pollution has adverse effects on the health and property of the nearby community who use the river water. Therefore, they want the pollution load released into the river to be zero. It is possible for the factory to adopt pollution abatement measures which can purify the effluents and reduce the pollution load to zero level. Installation of such technology, however, would increase the cost of production for the factory and keeping up with its objective of profit maximization the factory does not want to install pollution abatement measures. Thus a conflict in interest between the factory and the community is generated.