The resolution to the externality of pollution was to let the factory pay for the right to pollute and use the revenues to compensate the neighbors. Another solution would be to award the rights to the air to the factory and have the neighbors pay the factory to reduce its exhaust.
Ronald Coase (1910- ) was born in the U.K.. Even though he never gained in Ph.D. he went on to win the 1991 Nobel Prize in economics for his insights in the connections between law and economics. He pointed the attention at alternative legal arrangements in case of public goods and externalities. In one famous article he showed that the services of a light tower, until then one of the most common examples of a public good, could be sold at a price, and was-for 400 years! Coase is best known for two theorems named after him. They are discussed here in the text.
Ronald Coase noted in 1960 that in an ideal world where markets work well and the costs of making deals are very low it does not matter for the outcomes in the markets how property rights are assigned. This insight is known as Coase's first theorem:
Coase's first theorem states that when markets work well and the costs of making deals are low, efficient outcomes are guaranteed no matter how property rights are assigned.
Just imagine yourself in a world with perfect markets. When the neighbors have the rights to the air, they will require the cereal factory to pay. As a consequence, the factory will produce less cereal and its price will go up. All kinds of markets will be affected. The neighbors, for example, will use the payments to purchase storm windows and other goodies causing adjustments in the markets for those products. Prices will adjust until all markets have returned to their equilibrium. It's not different when the factory has the property rights. Then the neighbors will pay to reduce the production of cereal. Prices of cereal will go up as a result. Again a series of markets will need to adjust to a new equilibrium. So you see, in both cases the price of cereal will go up and its quantity produced and sold will be down.
Coase's First Theorem is merely Adam Smith's argument in thin disguise. Adam Smith postulated that markets will distribute goods as if by an invisible hand to those who value them most. It only makes the role of property rights more explicit.
Concept Check 3: People living in the area of a newly planned airport are usually vehemently opposed and prefer it will never be built. (What is the externality that they will fear most?) Use Coase's First Theorem to present alternative solutions to the problem.