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The Coase Theorem claims that parties may wish to bargain for a socially efficient outcome if one party’s property rights have been clearly violated by the actions of another party, so long as the bargain would not create an undue burden for either party.
For example, consider that Company X pollutes a local river that flows nearby Alice’s home and provides groundwater for her well. Pollution is a negative externality that clearly violated Alice’s property right to clean and untainted water fit for human consumption. Applying the Coase Theorem, Alice and Company X may wish to bargain for a settlement to preemptively avoid legal disputes.
Defining property rights is the cornerstone of the Coase Theorem, because the party who creates a negative externality may not be obligated or interested in pursuing a bargain if a person’s property rights were not violated. The Coase Theorem supports negotiations ex-ante, rather than ex-post becasue legal action is a less efficient method for resolving a dispute.