Question

1. In its production? process, Firm A uses 3 barrels per day of a harmful chemical that it dumps into an otherwise clear river that runs near its plant. The river? (and the? chemical) flows downstream to Firm? B, which uses the river water to make beer. Firm A has property rights to the river? water, and there are no environmental regulations against? dumping, so each day it costs Firm B? $5,000 per barrel? (a total of? $15,000 per? day) to clean up the water it uses to make beer.

Firm A can reduce the amount of chemical it dumps into the river from 3 to 2 barrels at a cost of? $2,000 per day. It can reduce the amount of chemical from 2 barrels to 1 barrel at an additional cost of? $4,000 per? day, and it can cut back from one barrel to none at a further cost of ?$7,000 per day. ?[Be sure you understand that these are marginal abatement costs. The cost of going from 3 barrels to no barrels is the sum of the marginal costs – ?i.e., $13,000 per? day.] If negotiations between Firm A and Firm B are? costless, what solution should the firms come? to?

A. Firm B should pay Firm A an amount between? $6,000 and? $10,000 per day to reduce the amount of chemical it dumps into the river from 3 barrels per day to 1 barrel per day.

B. Firm B should pay Firm A an amount between? $2,000 and? $5,000 per day to reduce the amount of chemical it dumps into the river from 3 barrels per day to 2 barrels per day.

C. Firm A should pay Firm B? $15,000 per day to compensate it for having to clean up the water.

D. Firm B should pay Firm A an amount between? $13,000 and? $15,000 per day to stop all dumping of the chemical into the river.

Suppose that Firm B? (the beer-making? firm) has the property rights to clean? water, and the firms can negotiate costlessly. What is the solution the firms should come to in this? case?

A. Firm A should reduce the amount it dumps from 3 barrels to 1 barrel per day and pay Firm B between? $5,000 and? $7,000 to allow it to dump the third barrel into the river.

B. Firm A should dump 3 barrels per day into the river and pay Firm B between? $13,000 and? $15,000 for the privilege.

C. Firm A should reduce the amount it dumps from 3 to 2 barrels per day and pay Firm B between? $10,000 and? $11,000 to allow it to dump the second and third barrels into the river.

D. Firm A should not dump any barrels into the river. Then it? won't have to pay Firm B anything.

Notice that the firms come to the same solution when Firm B has the property right to clean water as when Firm A has the property rights to dump. Of? course, Firm A has to pay Firm B when Firm B has the property rights while Firm B has to pay Firm A when Firm A has the property rights.

These examples show that when negotiation is? costless, bargaining will reach the same? (efficient) solution regardless of which party holds the property rights. This result is known as

A. the property rights paradox.

?B. Marshall's law.

C. the equivalence principle.

D. the Coase theorem

Answer 1

To reach an optimal solution, let us make a table of total cost incurred due to production of chemical waste by firm A:

No. of Barrels	Firm A	Firm B	Total Cost
3	0	15000	15000
2	2000	10000	12000
1	4000	10000	14000
0	13000	0	13000

It can be seen that the least cost solution is for Firm A to produce 2 barrels.

Answer 1:

B. Firm B should pay Firm A an amount between? $2,000 and? $5,000 per day to reduce the amount of chemical it dumps into the river from 3 barrels per day to 2 barrels per day

Answer 2:

C. Firm A should reduce the amount it dumps from 3 to 2 barrels per day and pay Firm B between? $10,000 and? $11,000 to allow it to dump the second and third barrels into the river.

Answer 3:

This is an example of Coase theorem. When negotiating costs are zero, optimal solution can be reached with bargaining irrespective of holder of property rights.