The efficiency of paying compensation in the Pigovian solution to externality problems

This note examines the efficiency of giving the victim of an externality the revenue raised by a tax on the injurer when the injurer and victim bargain with each other and act strategically. If the government has full information about the externality problem, then compensation is compatible with, but is not required for, the attainment of efficiency. If the government has limited information, then the desirability of compensation depends on the parties' behavior. In general, there is not an a priori case against compensation.