When one party’s (the impactor) activity adversely impacts the welfare of an unintended third party (the impactee), one tends to think that an external cost (negative externality) has been generated, and that the activity in question has been carried too far, and that the impactee should be compensated.
But in assessing the situation, it is useful to keep in mind the following points:
Ronald Coase (1960) pointed out that impactors and impactees have built-in incentives to negotitate an efficient level of adverse impact regardless of the assignment of rights when the negotiation cost (also called transaction cost) is negligible. The level of adverse impact is efficient when the marginal benefit to the impactor of additional adverse impact is just equal to the marginal cost to the impactee of suffering the additional adverse impact. Because further mutual gain via negotiation is impossible beyond this level, negative externality is deemed to have been internalized even though some adverse impact remains. The assignment of property rights determines who pays whom to arrive at this efficient level and whether this efficient level can be achieved at all when negotiation cost is substantial.Efficient adverse impact
Adverse impact to unintended third parties is bad for the impactee, but it may be a necessary byproduct of legitimate economic activities. For example, a blacksmith might generate noise adversely impacting the recording studio next door. The impactee, in this case the recording studio, is the innocent third party to the blacksmith's transactions with his customers. To eliminate adverse impact is to deny the existence of such a legitimate economic activity. A more reasonable solution is to have an efficient level of adverse impact.
Adverse impact is efficient when its net benefit is maximized. This happens when the marginal benefit to the impactor is equal to the marginal cost to the impactee, regardless of whether the impactor has the property right to generate adverse impact or the impactee has the right to zero adverse impact.
When an efficient level of adverse impact is achieved, negative externality is said to be internalized. But some adverse impact might remain. In other words, the presence of adverse impact in itself does not mean that negative externality is present.Impactor has right
The right to generate adverse impact generally means that the impactor does not have to compensate the impactee for harm done. But this right does not mean that a negative externality is present. It simply means that the impactee must pay the impactor to reduce the adverse impact to an efficient level. At the efficient level of adverse impact, some adverse impact might still be present, but negative externality has already been internalized. Negative externality can persist only if the right to generate adverse impact has not been or cannot be easily defined as in the case of common-pool resources.
Adverse impact created by rightful parties is not a case of market failure. In fact, it is a natural result of market activities. The market can usually deal with such adverse impact through negotiation between impactors and impactees. If the additional harm to the impactee is greater than the additional benefit to the impactor, the impactee will have the means to compensate the impactor to curtail the adverse impact. The end result is that the level of adverse impact is reduced to the optimum.
Impactee has right
Efficient right assignment
Instead, partial right could be granted in such a way the party that has lower cost of adjustment could unilaterally move to the efficient level of impact.
*Coase, R. H. "The Problem of Social Cost," Journal of Law and Economics. v. 3, no. 1 pp. 1-44, 1960.