Consider a city with a lake. The city has a resort whose visitors use the lake f

Question

Consider a city with a lake. The city has a resort whose visitors use the lake for recreation. The city also has a tannery 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 tannery's effluent decreases the resort's profit. Throughout this problem, assume the negotiations are costless.

Suppose that the tannery could use an alterantive 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 tannery uses the recycling method, then the tanner's profit is $15,000 per week, and th resorts profit is $17,000 per week. If the tannery does not use the recycling method, then the tannery's profit is $20,000 per week, and the resorts profit is $10,000 per week. The total (the tannery's profit and the resorts profit combined) is highest when the production method is ________ (USED / NOT USED).

When the tannery uses the recycling method, the resort earns $17,000- $10,000= $7,000 more per week than it does with no recycling. Therefore the resort should be willing to pay up to $7,000 per week for the tannery to use water recycling. However, the recycling method decreases the tanner's profit by $20,000-$15,000= $5,000 per week. Therefore, the tannery should be willing to use the recycling method if it is compensated with at least $5,000 per week. Suppose the resort has the property rights to the lake. That is, the resort has the right to clean (unpolluted) lake. In this case, assuming the two firms can bring bargain at no cost, the tannery will _________ (USE / NOT USE) the recycling method and will pay the resort _________ (BETWEEN $0 AND $2,0000 / BETWEEN $5,000 AND $7,000 / BETWEEN $2,000 AND $5,000 / $0) per week.

Now suppose the tannery has the property rights to the lake, including the right to pollute it. In this case, assuming the two firms can bargain at no cost, the tannery will _______ (NOT USE / USE) the recycling method, and the resort will pay the tannery ____________ (BETWEEN $0 AND $2,0000 / BETWEEN $5,000 AND $7,000 / BETWEEN $2,000 AND $5,000 / $0 ) per week. Which of the follow statements are correct?

Check all that apply.

1. The lake will remain polluted regardless of who has the property rights.

2. The tannery will only use the recycling method if it has the property rights.

3. The resort will make the most profit when it has property rights to a clean lake, and the tannery will make the most profit when it has the property rights to the polluted lake.

Explanation / Answer

In this problem there is a tanery ad a resort. Taery dumps waste in the river. It causes negative externality and reduces profit of resort. Thus in polluted condition profit of Tannnery is $20,000 and profit od resort is $10,000. Total profit is-

$20,000+$10,000=$30,000

Now Tannery has developed a ew technology of recycling water which will reduce pollution of lake water. On its use profit of Tanery will come down to $15,000 and for resort it will move upto $17,000. Thus total profit is-

$15,000+$17,000=$32,000.

Thus total profit is highest when recycling method is used.

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Now consider a situation when resort has property right on lake. So it will apply this right and will maintain the water pollution free so that maximum profit of $17,000 can be earned. In that situation Tanery has two options. In first option it will use recyle method of production and will not pay anything to resort. If this method is not used, then resort will try to recover $7,000 from tanery. But tanery will not pay it, since by paying $7,000 it is gaining only $5,000. So ultimately its net earning in unpolluted condition is $15,000-$7,000 = $8,000. Also note that if Tannery use recycled method total profit of the economy will be maximum.

Thus Tannery will use recycle method and will pay zero to resort.

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If tannery has the right to pollute the water, then under normal circumstances, tanery will ot use recycle method to earn highest possible profit of $20,000. Resort can bargain with the tannery to use recycle method, but it has to pay $5,000, so that gap in earning of tannery can be compensated. By paying this $5,000, Resort will earn $7,000 extra. So it has a net gain of $2,000. So the best option is to pay $5,000 to tanery so that recycle method is used.

Answer: Tannery will use recycle method and will get $5,000 from resort.

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From above analysis following poits are observed.

1. Lake will not remain polluted under any of the three situations discussed above. Thus statement of point 1 is wrong.

2. Tannery will use recycling method only if it gets $5,000 from resort. Other wise it will not be used. So second statement is also wrong.

3. Resort will make maximum profit when it has property rights to clean lake ad tannery will make maximum profit of $20,000 when it has property right to pollute the water. Thus statement 3 is true.

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