Coase Farm grows soybeans near property owned by Taggart Railroad. Taggart can b

Question

Coase Farm grows soybeans near property owned by Taggart Railroad. Taggart can build zero, one, or two railroad tracks adjacent to Coase Farm, yielding a net present value of $0, $9 million, or $12 million.

Coase Farm can grow soybeans on zero, one, or two fields, yielding a net present value of $0, $15 million, or $18 million before any environmental damages inflicted by Taggart trains. Environmental damages inflicted by Taggart's trains are $4 million per field per track. Coase Farm's payoffs as a function of the number of fields it uses to grow soybeans and the number of tracks that Taggart builds are shown below.
Zero fields One fields Two fields
Zero tracks $0 $15 $18
One track 0 11 10
Two tracks 0 7 2

It is prohibitively expensive for Taggart Railroad and Coase Farm to enter into a long-term contract regarding either party's use of its land.

a. Supose Taggart Railroad cannot be held liable for the damages its tracks inflict on Coase Farm. Show that Taggart Railroad will build two tracks and Coase Farm will plant soybeans on one field.
b. Suppose Taggart Railroad can be held fully liable for the damages that its tracks inflict on Coase Farm. Show that Taggart Railroad will build one track and Coase Farm will plant soybeans on two fields.
c. Now suppose Taggart Railroad and Coase Farm merge. Show that the merged firm will build one track and plant soybeans on one field.
d. What are the implications of the merger for the organizational architecture of the newly merged firm in terms of decision rights, performance measurement, and employee compensation.

Explanation / Answer

a. Because Taggart is not held responsible for the damage it causes on Coase Farm, the company will start building track when they will have the highest NPV, which is $12 million for two tracks. Coase will start growing soybeans in the amount of fields that generate the highest NPV for them. The other company builds two tracks, thus Coase will generate a net present value of $7 million when there is 1 field of soybeans and $2 million when there are 2 fields of soybeans. b. In this case, Taggart is responsible for causing damages on Coase Farm as follows: for 0 tracks, the NPV will be 0. for 1 track, the NPV is $9 million - $4 million (in damages) = $5 million for 2 tracks, the NPV is $12 million - $8 million (in damages) = $5 million We can see that NPV is higher for 1 track; so Taggart should go and build one track. Coase will have various fields of soybeans which would lead to higher NPV. Coase will generate NPV of $10 million since Taggart builds a single track. Coase will have two fields of growing soybeans as it has a higher NPV. c. For 0 tracks and 0 fields, the NPV of the merged firm will be 0. For 0 tracks and 1 filed, the NPV will be $15 million. For 0 tracks and 2 fields, the NPV will be $18 million. For 1 track and 0 fields the NPV is $5 million (9-4). For 1 track and 1 field the NPV is $20 million (9+11) For 1 track and 2 fields the NPV is $19 million (9+10) For 2 tracks and 0 fields the NPV is $4 million (12-8) For 2 tracks and 1 field the NPV is $19 million (12+7) For 2 tracks and 2 fields the NPV is $14 million (12+2). The best combination is 1 track and 1 field since it generates NPV of $20 million. d. An important decision if the merger occurs is regarding the production line that would have to be expanded or reduced. Also, they would have to determine the allocation of joint costs between the production lines. Another aspect would be determining the reduction in the cash flow of one project when undertaking the other project (cannibalization effect). They would have to consider if they need to lay off employees, and if this happens they need to think how to compensate them.

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