Question

Suppose that a paper mill earns $700,000 when it pollutes a river, and that it can abate pollution at a cost of $140,000. The effects of pollution are confined to a single farmer, who earns $530,000 if the water is clean and $230,000 if it is polluted. Assume that bargaining is frictionless and that the parties will split the gains from any agreement equally.

a. What agreement will the mill and the farmer negotiate if the mill has the right to pollute?

A. The farmer will pay the mill $220,000.

B. The farmer will pay the mill $140,000.

C. The mill will pay the farmer $220,000.

D. The mill will pay the farmer $140,000.

E. No agreement needs to be made.

b. What if the farmer has the right to clean water?

A. The farmer will pay the mill $220,000.

B. The farmer will pay the mill $140,000.

C. No agreement needs to be made.

D. The mill will pay the farmer $220,000.

E. The mill will pay the farmer $140,000.

Answer 1

The paper mill can abate pollution at cost of $140,000.

So, it will need at least $140,000 to stop polluting the river

If there is no pollution can increase the earning of farmer by $300,000 ( 530000-230000)

a) if the mill has the right to pollute then it would be beneficial for the farmer to give $140,000 to the mill to stop it from polluting the river as it will bring a gain of $160,000 ( 300000-140000) to the farmer.

So,

Ans - B)The farmer will pay the mill $140,000

b)

If farmer has the right to clean water then firm has to abate the pollution.

The pollution abatement cost for firm is $140,000. The pollution reduces farmer's revenue by $300,000.

So, either firm must abate pollution or pay farmer an amount equal to his loss.

Abating pollution is less costly for firm. So, it will abate pollution.

Thus, there would be no agreement needs to be made as the mill do not pay any amount to farmer but abate pollution.

So, Ans - C) No agreement needs to be made.