Question

17.20. A chemical producer dumps toxic waste into a river.The waste reduces the population of fish,reducing profits for the local fishing industry by $100,000 per year.
The firm could eliminate the waste at a cost of $60,000 per year. The local fishing industry consists of many small firms.

a) Using the Coase Theorem, explain how costless bargaining will lead to a socially efficient outcome, regardless of whether the property rights are owned by the chemical firm or the fishing industry.

b) Why might bargaining not be costless?

c) How would your answer to part (a) change if the waste reduces the profits for the fishing industry by $40,000? (Assume, as before, that the firm could eliminate the waste at a cost of $60,000 per year.)

Answer 1

a) According to Coase Theorem,private costless bargaining will lead to a socially efficient outcome, regardless of of the property rights. Note that in this case, the loss is borne by the fishing industry and is equivalent to $100,000. This can be prevented if the chemical plant is asked to dispose off this waste and for this it is compensated. Now chemical plant will bear a loss of at least $60,000 if it disposes off the waste but it will increase the profit of fishing industry by $100,000. Thus, a private bargaining solution arises where fishing industry offers a compensation of $60,000 (at least) to get rid of the waste. The bargaining works because the minimum compensation that chemical plant wants is $60,000 and the maximum compensation industry can provide is $100,000. Any amount between these two values will result in Coase bargaining solution.

b) Bargaining is not costless because there are costs of transaction and administration the bargaining process.

c) In this case bargaining fails because the minimum compensation that chemical plant wants is $60,000 and the maximum compensation industry can provide is $40,000. Since there is no common compensation, there is no bargaining.