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?

a) The tax.

b) None.

c) The contract.

d) Both deliver the same outcome.

Answer 1

1, Option 'a' is the correct answer. Tax is the best option to achieve socially optimum output. It is because in the question itself, it is stated that if the company chose contract, it has high transaction cost and this transaction cost can be treated as a dead weight loss of that contract. Dead weight loss is a social loss and prevents the society from achieving socially optimum   outcome. Another thing should be noted in the option to make a contract is, there may be some legal issues for enforcing such a contract by private companies. Thus it is better to choose the option of tax to cover the negative externality due to pollution (but it is necessary to transfer the collected tax amount by the government to the negatively affected company). From this it can be understood that tax is the best option than contract in this case and both cannot deliver the same outcome.