Question

Karen's cat causes Danny to sneeze. Karen values her cat's companionship at 300 per year. The cost to Danny of tissues and her allergy medication is 350 per year. Based on the Coase theorem, what is the optimal outcome for Karen and Danny?

1) Karen should keep her cat and pay Danny 300 per year to cover the cost of tissues and allergy medication.
2) Danny should pay Karen 300 per year to compensate for the inconvenience of his allergies.
3) Karen and Danny should negotiate a solution that maximizes their combined welfare.
4) Karen should get rid of her cat to avoid causing Danny any discomfort.

Answer 1

The optimal outcome based on the Coase theorem is for Karen and Danny to negotiate a mutually beneficial agreement that covers Danny's costs and compensates Karen appropriately, maximizing both their welfare.

Step-by-step explanation:

The Coase theorem suggests that if trade or bargaining is possible and there are no transaction costs, then parties can negotiate to solve the problem of externalities and allocate resources efficiently. The optimal outcome for Karen and Danny, based on the Coase theorem, is that they should negotiate a solution that maximizes their combined welfare. Since Karen values her cat's companionship at $300 and the cost to Danny for tissues and allergy medication is $350, they can negotiate a payment that covers Danny's costs but also compensates Karen for her loss if she were to give up her cat.