Rules favour the factory: No liability
Suppose that the legal regime is one of no liability. Then, in the absence of bargaining between the factory and the residents, the best that the factory can do is to produce at point I in Figure 3.4.3. Clearly this is
Figure 3.4.3 Bargaining around legal rules and the efficiency version of the Coase Theorem not a Pareto-optimal outcome - there are other allocations which make both parties strictly better off.
Suppose the residents try to persuade the factory to reduce its production by offering them money in exchange for a reduction in Q. Depending on the bargaining power of the parties and in the absence of transaction costs (both of which we examine in detail below), the parties could keep exchanging reductions in Q for increases in money until a point like is reached, where there are no remaining gains from trade. Note that in this example both parties are better off as a result of such trades, and that the final level of production, Q, is less than the level that would have been produced in the absence of bargaining. The factory ends up with more money than it initially started with, and the residents do not have to put up with as much Q.