4. Private solutions to externalities Aa Aa Consider a town with a river. The to

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4. Private solutions to externalities Aa Aa Consider a town with a river. The town has a hiking lodge whose visitors use the river for recreation. The town also has a chemical plant that creates industrial waste, which it dumps into the river. This pollutes the river and makes it a less desirable vacation destination. That is, the chemical plant's effluent decreases the hiking lodge's profit Throughout this problem, assume that negotiations are costless Suppose that the chemical plant could use an alternative production method involving water recycling. This would reduce the pollution in the river to levels safe for recreation, and the hiking lodge would no longer be affected. If the chemical plant uses the recycling method, then the chemical plant's profit is $15,000 per week, and the hiking lodge's profit is $17,000 per week. If the chemical plant does not use the recycling method, then the chemical plant's profit is $20,000 per week, and the hiking lodge's profit is $10,000 per week Total profit (the chemical plant's profit and the hiking lodge's profit combined) is highest when the recycling production method is When the chemical plant uses the recycling method, the hiking lodge earns $17,000 $10,000 $7,000 more per week than it does with no recycling. Therefore, the hiking lodge should be willing to pay up to $7,000 per week for the chemical plant to use water recycling. However, the recycling method decreases the chemical plant's profit by $20,000 - $15,000 $5,000 per week. Therefore, the chemical plant should be willing to use the recycling method if it is compensated with at least $5,000 per week Suppose the hiking lodge has the legal rights to the river. That is, the hiking lodge has the right to a clean (unpolluted) river. In this case, assuming the two firms can bargain at no cost, the chemical plant will the recycling method and will pay the hiking lodge per week Now suppose the chemical plant has the legal rights to the river, including the right to pollute it. In this case, assuming the two firms can bargain at no cost, the chemical plant will hiking lodge will pay the chemical plant the recycling method, and the per week

Explanation / Answer

The externality is the cost or benefit of an economic activity that spill over onto the society. A positive externality provides a benefit to the society and is called spillover benefit. The classic example of spillover benefit is education. A negative externality provides a cost to the society and is called spillover cost. The classic example of spillover cost is pollution.

The profit ($15000+$17000) is highest when recycling method is used.

Irrespective of right, the hiking firm's compensation is $7000 and that of chemical plant is $5000. Then it is better for chemical plant to use recycling at a cost of $5000 than pay hiking firm $7000. The hiking firm will happily pay the plant $5000 to induce it to use recycling.

Assuming the two firms can bargain at no cost, the plant will use the recycling method and pay the firm 0 per week.

The plant will use the recycling method and the hiking firm will pay $5000 to plant per weeek.

The correct option is

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