4. Private solutions to externalities Aa Aa E Consider a village with a lake. Th

Question

4. Private solutions to externalities Aa Aa E Consider a village with a lake. The village has a resort whose visitors use the lake for recreation. The village also has a chemical plant that creates industrial waste, which it dumps into the lake. This pollutes the lake and makes it a less desirable vacation destination. That is, the chemical plant's effluent decreases the resort'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 lake to levels safe for recreation, and the resort would no longer be affected. If the chemical plant uses the recycling method, then the chemical plant's profit is $10,000 per week, and the resort's profit is $18,000 per week. If the chemical plant does not use the recycling method, then the chemical plant's profit is $16,000 per week, and the resort's profit is $10,000 per week. Total profit (the chemical plant's profit and the resort's profit combined) is highest when the recycling production method is When the chemical plant uses the recycling method, the resort earns $18,000 - $10,000 = $8,000 more per week than it does with no recycling. Therefore, the resort should be willing to pay up to $8,000 per week for the chemical plant to use water recycling. However, the recycling method decreases the chemical plant's profit by $16,000 - $10,000 = $6,000 per week. Therefore, the chemical plant should be willing to use the recycling method if it is compensated with at least $6,000 per week. Suppose the resort has the legal rights to the lake. That is, the resort has the right to a clean (unpolluted) lake. In this case, assuming the two firms can bargain at no cost, the chemical plant will the recycling method and will pay the resort per week. Now suppose the chemical plant has the legal rights to the lake, including the right to pollute it. In this case, assuming the two firms can bargain at no cost, the chemical plant will the recycling method, and the resort will pay the chemical plant per week.

Explanation / Answer

The total profit is highest when the recycling method is not used as the profit with recycling is (16,000+10,000) or $26,000 per week which is less than (10,000+18,000) or $18,000 in absence of recycling method.

In the case when the resort has legal rights to the lake, the chemical plant will use the recycling method. If the chemical plant, in this case, would want to pay the resort for losses due to pollution, he must compensate the resort by at least $8,000 per week which is the loss to the resort. As using the recycling method will only decrease the profit of the chemical plant by $6,000 per week which is less than $8,000 per week, so it is better for the chemical plant to use recycling and pay the resort nothing.

Now when the chemical plant has the rights to the lake, the chemical plant will use the recycling method, and the resort will pay the chemical plant at least $6,000 per week (but less than $8,000). In order to make the chemical plant use the recycling method, it must be compensated for the profits forgone ($6,000 per week) plus the resort will be ready to pay the plant for using recycling less than $8,000 per week as the recycling would increase or say would not let the profits of resort decrease by $8,000 per week.

First one is true (read the above paragraph). Second is false as in both cases the recycling method will be used. The third is also false, as the chemical plant will use recycling when the resort will have the legal rights.

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