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

Answer (i): It is given that the external Medical bill cost due to pollution = $3,000,000

                   & the suppressed property value = $1,000,000

                  Therefore, the total external cost of pollution = $3,000,000 + $1,000,000

                                                                                                    = $4,000,000   

Answer (ii): It is given the factory makes a total profit = $5,000,000

                     & total external pollution cost = $4,000,000

           Therefore, if the factory is forced to consider the total social cots of pollution, then its profit=

                                                                   $5,000,000 - $4,000,000

                                                               =$1,000,000

        Hence, the factory would still make a profit of $1,000,000

Answer (iii): For the Profit of the factory to become Zero, it has to be taxed $5,000,000

                     The society can tax the factory anything less than 125% so that profit earned by the factory is not 0. This is because 125% of $4,000,000 is $5,000,000, which is the total profit earned by the factory.

Answer (iv): The Coase theorem suggests that in a situation where there is a potential conflict between society and ay firm, where the external costs from the pollution emanating from the firm is causing negative value for the society, the firm and the society should get together in a deal where both can their desired compensation. This is advisable because, it is possible that there could arise a situation when the society might move to law or court seeking their right for a pollution free livelihood. In that situation, it will come down to whether the production value generated by the firm is greater than the pollution negative value generated by the firm. In such a situation, the decision of the court might more preferably go in favor of the citizens of the society, as there are lives of the people at stake. Or if the pollution emitted is much lesser than as depicted by the people, then the court my deliver the verdict in the favor of the firm. In either case, both the firm and the society will loose precious capital and time. Therefore, both the parties should get in to a deal and accept the compensation they each get.