Final answer:
The Ronald Coase Theorem states that the efficient allocation of resources in the presence of externalities is achieved through well-defined property rights, provided transaction costs are low. This is illustrated through an example of a dispute between a farmer and a railroad over damage caused by train sparks. Property rights determine which party is responsible for mitigating the damage.
Step-by-step explanation:
The Ronald Coase Theorem is a principle in environmental economics and law that asserts that if property rights are well-defined and transaction costs are negligible, the allocation of resources will be efficient regardless of who holds the rights. It addresses situations where there are externalities, such as pollution or other types of spillover effects. Coase illustrated this with the example of a railroad and a farmer where the train's emissions cause damage to the farmer’s field. The resolution lies in clearly defining whether the farmer has the right not to have his field burned or if the railroad has the right to operate its trains without additional responsibilities.
Once the legal responsibilities are established, the entity holding the property rights will naturally seek the most cost-effective solution to minimize the negative impact. If the railroad has the responsibility, it might install a device to reduce sparks; if the farmer is responsible, building a fence could be the solution. The theorem emphasizes the importance of better-defined property rights to solve such disputes and establish a balance between different parties' interests.