Question

"Assume that you have a factory that produces frozen food and uses water from the river next to you. There is another plant that produces chemical waste and throws it to the river, such waste gets to you when you pull water from the river. Thus, you must pay for a very expensive process of cleaning the water. There are two possibilities to correct this externality: One is to engage into a contract with the other plant, such that they compensate you for how much you invest in cleaning the water. This contract has high transaction costs, that vary a lot and there is uncertainty about whether you can enforce such contract. The other one is for the government to tax them by the amount you need to pay to clean the water. What solution allows for the achievement of the socially optimal outcome?"

Answer 1

tax

Step-by-step explanation:

Tax is really the strongest alternative for achieving maximum social efficiency. That is because it is defined previously itself that even if the company opted for a contract, this has high operating costs and this transaction cost can be treated as a dead weight loss of that contract.

The loss of dead weight is a social loss and prevents the social system from achieving socially optimal results.Another factor that should be noticed about the contract process is, there might be certain compliance problems with private parties to execute such a deal.