Question

Collectively, the 1000 residents of River Heights value swimming in Red River at $100
000. A nearby factory pollutes the lake water, and would have to pay $50 000 for nonpolluting equipment.
a) Describe a Coase-like private solution.
b) Discuss about five reasons why this solution might not work in the real world?
c) Discuss two public policies that can correct the externality and which one will be more
efficient.

Answer 1

a) The Coase theorem states that private parties can find efficient solutions to externalities without government intervention, the parties affected by an externality will bargain to reach an outcome that will be more efficient. So the Coase like private solution for the given problem would be that the residents and the factory bargain among themselves and the factory is ready to pay for the resident's loss or the residents can let off the factory to pollute will give the private solution to the problem.

b) This solution might not work in the real world because -

• For coase theorem to work, transaction costs must be low in order for parties to arrive at a more efficient outcome but In the real world, transaction costs are rarely low, so the Coase theorem is often inapplicable.
• There is need of some agent between the two parties for the bargain process.
• The bargain always doesn't reach to a mutually accepted point.
• There may be lack of coordination between the two parties.
• A person creating a negative externality generally don't want to pay anything unless forced by law but it is not possible in private negotiation.

c) The two public policies which can be adopted to correct the problem may be -

• Firstly imposing a tax on the factory polluting the river.
• Secondly imposing a regulation that the factory must treat wastes before disposing off into the river.