Definition
The Coase theorem, developed by economist Ronald Coase, states that if property rights over a resource are clearly defined and the cost of bargaining is negligible, then private parties will negotiate their way to an efficient outcome regardless of which party initially holds the rights.
Its surprising implication is that, under those ideal conditions, government intervention is not required to fix an externality. The role of the law is mainly to assign rights clearly so bargaining can proceed.
Why it matters
How it works
Suppose a factory's smoke harms a neighboring farm. If the farm holds the right to clean air, the factory must pay to pollute; if the factory holds the right to emit, the farm must pay it to cut back. Either way, the two parties bargain until they reach the same efficient level of pollution — the assignment of rights affects who pays, not the final outcome.
The theorem's power lies in its conditions. When bargaining is costly — many parties, poor information, holdouts — private negotiation breaks down, and the theorem identifies exactly where government action is warranted. Cap and trade can be read as a way of lowering those transaction costs at scale.