When an action by one party harms another and the parties are able to negotiate costlessly with one another, the negative externalities are dealt with efficiently regardless of whether the law makes people liable for the harmful effects of their actions. This result is known as the Coase theorem. When negotiation is costly, it does matter how liability is assigned. In general, the most efficient outcome occurs when the law places the burden of avoiding harmful effects on the party that can accomplish it at the lowest cost. This general principle sheds light on a variety of questions regarding the design of property rights. In many instances, the laws of property have been set up to generate the kinds of accommodations people would reach for themselves if they were free to negotiate costlessly with one another. Similar conclusions apply in situations that involve positive externalities. If negotiation is costless, people will forge agreements that result in efficient outcomes, even in cases where one party's activities create indirect benefits to the other. And where negotiation is costly, institutions tend to evolve that encourage activities with positive external effects. In contests for relative position, as in all other contests, the efforts by one contestant confer a negative externality on other contestants: anything that increases one party's odds of winning necessarily reduces the odds of others. The effect is almost always to induce some form of arms race among contestants, in which the efforts of each party serve largely to offset one another. The theory of externalities and property rights sheds a great deal of light on the laws by which citizens of modern societies restrict such arms races. Taxation is one solution to the problem of negative externalities. Although it is not always an ideal answer, it does offer several important advantages over direct regulation in many situations. Taxation of negative externalities provides a source of governmental revenue that is largely exempt from the allocative inefficiencies we encountered in Chapter 16. | 
2002 McGraw-Hill Higher Education