Question

. Jones owns a restaurant whose patrons value quiet. Everything was fine so long as Chez Jones was located next to a florist, but the florist shop is replaced by a dance studio , owned by Smith, which generates a high level of noise. Assume that without any soundproofing, Jones loses $200 in profits in lost sales from customers who don’t eat at her restaurant because of the noise from the dance studio. Suppose further that Smith could install soundproofing that would completely reduce the noise at a cost of $150. Assume further that property rights are such that Smith is under no legal obligation to abate noise resulting from his operation Without Soundproofing With Soundproofing (Change in) Smith’s Profit +$150 0 (Change in) Jones Profit -$200 0 a. Would it be economically efficient in this example for someone to spend $150 to abate the noise caused by the dance studio? (Briefly explain your answer). (5 points). b. Assume that there are no transactions costs to bargaining between Smith and Jones. What does Ronald Coase predict would happen in this case? (10 points). c. Suppose instead that the total costs of bargaining between Smith and Jones equaled $75. Would your answer to b change in that case, and if so how? (8 points). d. In the case of c can you recommend an economically efficient policy? (7 points). Note no graphs are needed to answer this question. Work with the data in the problem to reason to the answers.

Answer 1

a. The provided information has been summarized into a table for easier understanding. Since Jones loses $200 without sound proofing, a minus sign is written before $200 to indicate the loss. It has been mentioned that without soundproofing, Smith earns $150. However, since the cost of soundproofing his studio is $150, in the case of soundproofing, his profit reduces to 0.

	JONES ($)	SMITH($)
WITHOUT SOUNDPROOFING (WS)	-200	150
WITH SOUNDPROOFING (S)	0	0

When the total surplus is calculated under both the cases, the total surplus under WS is -200+150=0-50. That under S is 0. Even if Smith is under no legal obligation to soundproof his studio on the basis of property rights, since the total surplus is greater in case of soundproofing, it is “economically efficient” to spend $150 and soundproof the area. This is because, the economy’s goal is to maximize the value of production (or total welfare/surplus) and it doesn’t matter who does what. The alternative that gives a higher total surplus is always chosen.

b. According to Coase theorem, in the presence of perfect competition, perfect information and no transaction costs, rational economic agents will come to a bargain which will result in the most efficient allocation of resources in the economy, and the costs due to any externality will get corrected. In this case, due to absence of transaction costs, the following Coase solution will take place:

In order for Jones to be satisfied with noise, Smith would have to give him more than $200 to compensate for his loss of $200. This is more expensive than spending $150 and sound proofing the studio. However, since there are no property rights that give Jones the right to demand soundproofing, Smith will have no incentive to spend out of his own pocket to soundproof his studio. In this case, Jones would offer Smith $150 to soundproof the studio. This way, Smith doesn’t have to spend and gets the soundproofing done. Jones too benefits by spending $150 once for all, rather than incurring a loss of $200. Thus, the new table with two alternatives is as follows:

	JONES’ surplus	SMITH’s surplus	TOTAL SURPLUS
NO SOUNDPROOF	-200	150	-50
SMITH spends to Soundproof	0	(150-150=) 0	0
JONES spends to soundproof	(200-150=) 50	0	50

Therefore it is clear that following Coase Theorem, Smith and Jones will reach an agreement where Smith will soundproof the studio and Jones will pay for it (in the absence of property rights giving Jones the legal right to compel Smith to soundproof on his own).

c. Now, if there is a total cost of bargaining worth $75, the scenario would be different. In this case, Jones would not only have to pay $150 to Smith for soundproofing his studio, but would also have to incur a bargaining cost of $75. This implies that his total cost increases to $150 to $150+$75 = $225. This cost of $225 is greater than the loss incurred by Jones worth $200. Thus, Jones would choose not to bargain ($75) and pay for Smith’s soundproofing ($150) and would rather choose to bear the loss without soundproofing ($200<$225) as in monetary terms, the loss due to not soundproofing is less than the cost due to soundproofing ($225). Since Smith has no incentive to soundproof anyway, there is no question of him initiating a bargain and soundproofing on his own by incurring an additional cost of $150+$75 = $225. Even if Jones does agree to pay $200 (his maximum willingness to pay to cover the loss) Smith wouldn’t agree to shell out $25 from his pocket. This is because he has no incentive to soundproof his studio for the benefit of someone else. Thus, the Coase theorem fails in this case and a bargaining doesn’t happen. In this case, the total surplus of the economy in case of soundproofing becomes negative. (-$25 [Jones’s surplus ($200-$225)] + $0 [Smith’s surplus]= -$25)

d. Given this scenario, the government’s intervention with property rights is required to ensure that Jones is compelled to soundproof on his own. This administrative decision replaces the transaction costs and increases efficiency in the economy. In the presence of property rights, Smith would have to soundproof his studio. The transaction costs of $75 vanish as there’s no question of bargaining anymore. Jones’s surplus increases from -$200 to $0. Smith’s surplus falls from $150 to 0. The total surplus increases from a negative $25 (in case c) to a positive $0. Thus, the economy is better off and total surplus is maximized. However, this answer assumes that the administrative costs of imposing property rights is less than $75 worth of transaction costs. Had this not been the case, then the answers would’ve been different. The costs are weighed out and the alternative that minimizes total cost and maximizes total gain of the economy is chosen.