Question

A cement factory pollutes a nearby restaurant. The pollution reduces the profit of the restaurant by $500,000. The restaurant could install equipment to clear the pollution but that would cost $250,000. Alternatively, the factory could install equipment to prevent the pollution at a cost of $350,000.

a.

Discuss the Pigouvian solution.

b.

Discuss the Coasean solution if the restaurant has the right to a pollution free environment. Also discuss the Coasean solution if the factory has the right to pollute.

c.

For this example, which solution is better from the social point of view, the Pigouvian or the Coasean? In general, under what circumstances is the Pigouvian solution likely to be better and under what circumstances is the Coasean solution better?

Answer 1

a)

Since here the firm is causing the negative externalities. Such external costs are considered by the firm while taking a decision regarding the level of output.

Thus, the government imposes the tax on the polluting activities of the factory. Such tax is called the Pigouvian tax, it will reduce the level of pollution by forcing the firm to internalize the externalities.

b)

Coase theorem says that if property rights are appropriately demarcated, system will reach socially optimal level automatically.

If restaurant is assigned the property right, then factory would be made to set up the pollution control equipment costing 350 000.

On other hand, if factory has right, then restaurant will go for the pollution control equipment thereby saving profit equal to $ 250000

c)

Pigouvian intervention requires that government intervention is needed while coasian does not require such action. Coasian prescription is better if size of market is small or number of parties involved in the party is limited. Free rider problem rises if size of market is larger.

When number of parties is larger, Pigouvian solution would be right action.