Question

A firm produces 40 machines. Each machines creates pollution costs worth 10 on the local farmers.

The firm could install filters for 160, which would eliminate the pollution. Or the farmers could buy more resilient crops for 80 (in total) which would cut the pollution costs in half.

Assume property rights are with the firm. How high can the transactions costs of negotiation be at most before the Coase solution becomes unattainable?

Answer 1

Note that firm has property rights so it will not install filters unless it is compensated for them by at least 160. Farmers face a loss of 10 x 40 = 400 so they can compensate the firm but then if they spend 80 for more resilient crops, they will face a pollution cost of 200 now. To get of this loss of 200, they would be agree to pay an amount less than 200 to firm for installing filters and firm must be given an amount of at least 160 so that it recovers the cost of filters. Hence the transaction cost can be as high as this difference which is 40.