QUESTION 4

(a) State the Coase Theorem. Discuss at least two reasons why this private solution to the problem of externalities may fail to apply.

(b) Consider the interactions between a chemical firm situated on the banks of a river and a swim club located downstream from the chemical firm. The chemical firm benefits from polluting the river while the swim club suffers from any pollution of the river. Specifically, let the marginal benefit of pollution C of the chemical firm be MBF = 20 - C, and let the marginal cost of pollution to the swim club be MCS = 5+0.5C.

(i) What is the efficient level of pollution? Provide a graphical representation.

(ii) If the swim club is given the property right to the river: (1) what is the minimum total payment the swim club would be willing to accept to allow the firm to pollute the river to the efficient level?, (2) what is maximum total amount that the firm would be willing to pay to pollute the water to the efficient level?, (3) what is the swim club's gain if water rights are traded at the equilibrium price (i.e. price associated with the efficient level of pollution)? Represent these areas in the graph.

(iii) If the firm has the property right to pollute the water: (1) what is minimum total payment the firm would be willing to accept to reduce water pollution to the efficient level?, (2) what is the maximum total amount that the swim club would be willing to pay the firm to reduce pollution to the efficient level?, (3) what is the swim club's gain if water rights are traded at the equilibrium price (i.e. price associated with the efficient level of pollution)? Represent these areas in the graph.