Question

Suppose that the fish cannery could use a different production method that involves recycling water. This would reduce the pollution in the lake to levels safe for recreation, and the hiking lodge would no longer be affected. If the fish cannery uses the recycling method, then the fish cannery's economic profit is $2,200 per week, and the hiking lodge's economic profit is $3,200 per week. If the fish cannery does not use the recycling method, then the fish cannery's economic profit is $3,000 per week, and the hiking lodge's economic profit is $2,000 per week. These figures are summarized in the following table.

Complete the following table by computing the total profit (the fish cannery's economic profit and the hiking lodge's economic profit combined) with and without recycling
Profit
Fish Cannery Hiking Lodge Total
Action (Dollars) (Dollars) (Dollars)
No Recycling 3,000 2,000 ___
Recycling 2,200 3,200 ___

Total economic profit is highest when the recycling production method is _______.
When the fish cannery uses the recycling method, the hiking lodge earns $3.200-$2.000= $1.200 more per week than it does with no recycling. Therefore, the hiking lodge should be willing to pay up to $1,200 per week for the fish cannery to recycle water. However, the recycling method decreases the fish cannery's economic profit by $3.000-$2.200=$800 per week. Therefore, the fish cannery should be willing to use the recycling method if it is compensated with at least $800 per week.
Suppose the hiking lodge has the property rights to the lake. That is, the hiking lodge has the right to a clean (unpolluted) lake. In this case, assuming the two firms can bargain at no cost, the fish cannery will not use ? the recycling method and will pay the hiking lodge ______ per week.
Now, suppose the fish cannery has the property rights to the lake, including the right to pollute it. In this case, assuming the two firms can bargain at no cost, the fish cannery will _____ the recycling method, and the hiking lodge will pay the fish cannery ______ per week.

Answer 1

The fish cannery will adopt the recycling method, and the hiking lodge will pay the fish cannery an amount between $800 and $1,200 per week. This arises from the Coase Theorem, which predicts private bargaining to solve externalities when property rights are assigned, and there are no costs to bargaining.

Step-by-step explanation:

Given that the fish cannery holds the property rights to the lake, including the right to pollute it, the scenario implies a direct application of the Coase Theorem. This theorem suggests that if there are no costs to bargaining and property rights are clearly defined, private parties can negotiate compensation to solve the problem of externalities. In this case, the pollution from the fish cannery affects the profits of the hiking lodge, creating an externality.

In the example provided, if the fish cannery uses the recycling method, it suffers an opportunity cost of $800 per week in terms of foregone profits, as its profit decreases from $3,000 to $2,200. On the other hand, the hiking lodge sees an increase in profit from $2,000 to $3,200, resulting in a net gain of $1,200 per week when the recycling method is employed. Given the Coase Theorem, the two firms can bargain to reach an efficient outcome where the cost of pollution is internalized.

Since the hiking lodge would benefit more from the recycling than it would cost the fish cannery, it should be willing to compensate the fish cannery to motivate them to implement the recycling method. The annual amount that the hiking lodge is willing to pay could range up to $1,200, as it is the additional profit the lodge would earn from the clean water. The fish cannery would require at least $800 to switch methods. Depending on the bargaining skills of the parties, the final compensation could be anywhere between these two values. However, we can conclude that the cannery will switch to the recycling method, and the hiking lodge will likely pay the cannery somewhere between $800 and $1,200 per week.