Question

Suppose: • the firm is required to reimburse the neighbors for pollution damage

• there are no transactions costs, and

• it is impossible for the neighbors to move.

8. What quantity does the firm produce and why?

Suppose: • transactions costs are so high that negotiation is impossible

• it would cost the neighbors $6 to move.

• there is no legal penalty for pollution.

9. Do the neighbors move? Why or why not? What is the social gain?

Answer 1

(8)

The firm is required to reimburse the neighbors for pollution damage.

- There is no transaction cost

- It is impossible for neighbors to move.

Since firms need to reimburse their neighbors, the cost of production for the firm rises. It will lead to an increased price of the product and a fall in quantity demanded. This new equilibrium point is known as Socially efficient.

(9)

If the negotiations are impossible then the moving cost for neighbors is $6.

Case 1: If the external cost of pollution is less than $6 then neighbors will not move.

Case 2: If the cost of external cost is equal to $6 then they will be indifferent between moving and not moving.

Case 3: If the cost of external cost is more than $6 then the neighbors will move out.

It is assumed to have only one period. The decision of moving or not-moving depends on the cost of the external cost and the moving cost. Neighbors will maximize their benefits by choosing to incur less cost.

Social gain refers to the total increase in surplus or market surplus. When the negative externality exists then it increases the cost for the other party. If there is no pollution penalty then firms will overproduce which leads to external cost.

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