Question

A local town is under pressure from voters to close a polluting factory. The head of the homeowner’s organization argues that the pollution is a menace, and if the full external costs of the pollution were calculated, the factory would not be profitable. The homeowners calculate that the pollution generates an external cost of $3,000,000 per year in medical bills and $1,000,000 per year in suppressed property values, which reflects the difference in home prices with and without pollution. That factory makes a profit of $5,000,000 per year.

i.What is the external cost of the pollution?
ii.If the factory is forced to consider the total social costs of pollution, would it be profitable?
iii.How much could the town tax the factory before profits become zero?
iv. What does the Coase theorem suggest about negotiations between the town and the factory?

Answer 1

The external cost of the pollution is $4,000,000 per year. If the factory considers the total social costs of pollution, it would not be profitable. The town could tax the factory up to $5,000,000 per year. The Coase theorem suggests that negotiations between the town and the factory could reach an efficient outcome.

Step-by-step explanation:

The external cost of the pollution can be calculated by adding up the medical bills and the suppressed property values. In this case, the external cost is $3,000,000 + $1,000,000 = $4,000,000 per year.

If the factory is forced to consider the total social costs of pollution, it would not be profitable.

The factory's profit is $5,000,000 per year, while the total social costs of pollution are $4,000,000 per year.

Therefore, the factory would be operating at a loss if it had to consider the external costs of pollution.

The town could tax the factory up to $5,000,000 per year before the factory's profits become zero. Any tax amount higher than that would result in the factory operating at a loss.

The Coase theorem suggests that negotiations between the town and the factory could potentially reach an efficient outcome.

According to the theorem, if property rights are well defined and transaction costs are low, the town and the factory could negotiate a mutually beneficial agreement to reduce the pollution levels or compensate for the external costs.