Question

Private solutions to correct for externalities

Suppose that a flower nursery benefits from having a butterfly farm located only a few miles away, because the presence of the insects greatly improves flower pollination. Lawyers for the two companies meet to draft a legal document specifying the number of butterflies the farm promises to maintain in exchange for payments by the nursery. The need for highly paid lawyers to work out a legal agreement between the flower nursery and the butterfly farm contradicts an important requirement of —the Laffer curve / the Coase theorem / Arrow's impossibility theorem namely, that the parties experiencing an externality must be able to go to small claims court / agree on an equitable initial distribution of rights / bargain at low cost​​​​​​​.

Answer 1

Question 1

In presence of externalities, two parties can negotiate for the optimal solution regardless of who posses the propoerty right provided that negotiation costs are nigligible or low.

This outcome is asserted by the Coase Thoerem.

In the given case, two parties wants to negotiate with respect to a positive externality but are engaging highly paid lawyers for the task.

This indicates the presence of high negotiation costs.

Thus,

The need for highly paid lawyers to work out a legal agreement between the flower nursery and the butterfly farm contradicts an important requirement of the Coase theorem namely, that the parties experiencing an externality must be able to bargain at low cost.