Assume existing Suppose you council such that you areysowhich emits smoke (pollu

Question

Assume existing Suppose you council such that you areysowhich emits smoke (pollution) during production laws are such that you are not allowed emit filtering, smoke from your factory are shown own a I in which your emit smoke unless you get permission from the city s located.) The relevant total costs and benefits of emittingor Surplus for your factory Surplus for the eity Factory emits smoke $200 Factory filters smoke $160 $420 $400 pose you are currently negotiating with the city. Is there a deal in which your ory is permitted to emit smoke? Ir so, provide the details of a deal allowing moke emissions. If a deal cannot be reached, explain why 4 marks Describe at least one of the key conditions needed for successful application of the Coase theorem to solving problems caused by externalities) [2 mark b)

Explanation / Answer

Solution:

a) We are given that if the factory emits smoke, surplus to factory= $200, and to city = $400, whereas if factory filters smoke, surplus for factory reduces to $160 (reduced due to filtering cost, which could be done by buying new equipment which is more effective in reducing pollution while production, or may be without equipment, due to reduced production levels such that pollution emitted is also less) and increases city's surplus to $420 (since, reduced pollution level). So, if the pollution is filtered, the firm has to face the filteration cost of (200 - 160=)$40 (loss in factory's surplus), while if it doesn't, the city will have to face emission cost of (420 - 400=)$20 (loss in city's surplus). According to the Coase theorem, such externality can be internalized, such that they reach an outcome which is better for both the parties (pareto improvement). So, to get the permission from the city to emit pollution, factory will have to compensate the city with the surplus loss caused due to the pollution.

Note that as per the question, here property rights lie with the city, so factory will have to get the permission by compensating the city for it's loss. Since, here the filteration cost (faced by factory) is greater than the emission cost (faced by city), i.e, 40>20, yes there exists a deal in which factory can be permitted to emit smoke. Since, compensation amount from factory to city is $20, which is less than factory's surplus loss due to filtering cost, if factory owner (me) pays the city any amount greater than or equal to 20, thereby compensating for loss caused by pollution entirely, city will accept the deal, and even factory owner will be better-off (by paying less than $40, which it would have otherwise had to pay). So any amount, x, transferred from factory owner to city with x lying between $20 and $40 (20<=x<=40), it's a good deal for both, the factory owner and the city.

b) Key conditions needed for successful application of Coase theorem:

1) Well defined property rights: Property rights define the ownership of a resource/product/service, specifying how that resource/product/service can be used. Like we have seen in the above part, it's clear that the ownership was with the city, or the city had property rights to clean or pollution-free environment, so we knew who had to compensate who. If the property rights are not clearly defined, any party could claim to have the ownership of a resource, thereby not bringing out any end result, as none would be willing to pay the other party/parties involved. Thus, no internalization of the externality could happen, as defined by the Coase theorem.

2) No or low transaction/bargaining costs: This says that the parties involved should not incurr any or very low bargaining/transaction costs which refers to costs such as time cost lost in bargaining, communication involved, etc. If such costs exists highly, these costs would also have to be included in costs of getting rid of negative externality (filteration cost above), or trying to sustain it (emission cost above), and with such additional costs, parties will rather avoid to bargain and reach on to a common, beneficial outcome.

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