Economics 229: Law and Economics

Fall 2024
Problem Set #2: Suggested Solutions

1. Smelly Pigs?

A. If LP acts selfishly, it will ignore the damage done to the neighbors. The
marginal benefit of selling another pig is 1,600 (note: LP is a price taker so its
quantity does not change the price for which it can sell). The marginal benefit of
the 8th pig is 1,600 so this pig just breaks even for LP. The 9th pig would reduce
LP’s profit.

Another way to check this answer is to consider LP’s profit, which is its revenue
minus its cost. The profit from seven pigs is 6,300; the profit from eight pigs is
6,400; and the profit from nine pigs is 6,300. Thus, raising eight pigs maximizes
profit.

B. The socially efficient solution would balance the private gains of LP with the
burdens faced by the neighbors. Considering the marginal conditions for the
optimal solution, the marginal revenue still captures the benefit to society, but
now the marginal social cost is the sum of the marginal private cost (i.e., LP’s
marginal cost) and the marginal external cost (i.e., the marginal damage). At a
quantity of four pigs, the marginal benefit is 1600 and the marginal social cost is
1600 (= 800 + 800).

You can check this answer by considering the total benefit less total social cost
(i.e., cost plus damage). This total is 3,200 for four pigs but drops to 3,000 for
either three or five pigs.

C. What mechanisms might facilitate moving to the socially efficient outcome? One
possibility is bargaining. In part A, LP’s profit is 6,400. In part B, LP’s profit is
4,800 – a drop of 1,600. However, the harm to the households drops from 6,400 to
1,600 when quantity drops from 8 to 4 – a gain of 4,800. This difference in the
lost profit and the benefit of harm reduction creates a bargaining range. If LP has
the right to make a smell, then if the homeowners can band together and offer a
payment of greater than 1,600, they can get LP to cut back to four pigs. It seems
reasonable if they can overcome coordination costs.

However, the smell affects many people so private bargaining might struggle to
solve this problem. Free riding might be a problem and a reason to turn to the
government. If the government understands the costs and benefits (possibly a big
assumption), then it could mandate that LP limit its size to no more than four pigs.
This mandate could come through legislation or through the court system as an
injunction. Another possible solution is for the government to tax LP’s output. A
corrective tax of 800 per pig (i.e., the marginal damage at the socially efficient
 output level) will do the trick. This tax is the optimal Pigouvian (corrective) tax.
Facing this tax, LP would maximize its profit with a quantity of four pigs.

D. The possibility of the improved diet does not change the incentives for a selfish
farmer since the output market does not pay a higher price of the alternative diet.
Thus, the answer to part A stays the same.

The socially efficient outcome does change. Considering the marginal conditions,
the solution balances the marginal benefit (still 1,600) with the marginal private
cost (add 100 to the MC in the table) and the marginal damage (cut the marginal
damage in the table in half). Using the formulas for marginal cost and marginal
damage, one can solve for q* from

MB = MC + MD
1,600 = 200q + 100 + 100q
Q* = 5

Checking the answer using the totals:

At q = 4, net social benefit is 6400 – 1600 – 400 – 800 = 3600

This formula is revenue less the base line cost of the pigs less the cost of the
improved diet less the damage given the improved diet.

At q = 5, net social benefit is 8000 – 2500 – 500 – 1250 = 3750

At q = 6, net social benefit is 9600 – 3600 – 600 – 1800 = 3600.

The potential solutions get a bit more complicated. Bargaining requires

negotiating both the number of pigs and their diet. Who is going to monitor what
the pigs eat?

The regulatory solution must also specify the quantity and the diet. The
regulators or the court would need to verify the diet of the pigs.

Even the tax solution gets trickier. A tax that is equal to the marginal damage at q
= 5 (i.e., a tax of 500) would not solve the problem unless it is conditional on LP
using the better diet. Thus, the tax would need to include a regulation.
Alternatively, a pure price solution would have two parts: (1) a tax on output of
500 per pig; and (2) a subsidy of 100 (or just a bit more) per pig for using the
cleaner feed. It certainly seems like a messy policy to implement.

2. Bargains
 In producing widgets, Acme Manufacturing generates pollution that it dumps into
Clearwater Lake. While Acme knows that the pollution upsets local citizens who like to
fish, it does not know the extent to the damage. The damage can be measured by how
members of the Clearwater Fishing Association (CFA) value having a clean lake. The
CFA knows for certain how much its members are hurt by the pollution, but it cannot
credibly communicate this information to Acme. Instead, Acme is uncertain about the
value of the damage. Acme believes that there is 50% probability the Clearwater Fishing
Association (CFA) would be indifferent between receiving $20K with the pollution and
not having any pollution and a 50% probability the CFA would require a minimum of
$40K to be compensated for pollution.

Acme could wipe out all pollution by installing a new technology at a cost of $17K,
while maintaining all the same revenues and costs (e.g., wiping out the pollution will
reduce Acme’s profits by $17K). (You should think of all the costs and benefits as
adding up all the costs and benefits over time.)

(a) Is the new technology socially efficient? Why?

ANSWER: The new technology is socially efficient because the cost of the technology ($17K)
is less than the damages caused by pollution (i.e., either $20K or $40K). Note that the key to
social efficiency is whether the technology is installed – it is not about who pays for it.

(b) Suppose that a court declares that Acme has the right to pollute the water, and also
gives Acme the power to a take-it-or-leave-it solicitation of a transfer (i.e., a bribe)
from the CFA in exchange for installing the new technology. That is, Acme can only
make one offer of an amount it would be willing to install the new technology and the
CFA cannot make a counteroffer. In other words, Acme has both the property right
and the bargaining power. What offer could Acme make that would maximize its
expected profit? Does this result in the socially efficient outcome?

ANSWER: The challenge for Acme is that it does not have perfect information about CFA’s
damages. If Acme asks for $20K to install the new technology, CFA will always accept. Acme
will have $20K in revenue but a cost of $17K for the new technology. Acme’s profits would
increase by $3K. However, if Acme asks for $40K, then CFA will only accept when the damage
is $40K. Thus, half the time Acme gets no additional profit, and half the time Acme gets an
additional $23K in profit (i.e., it receives $40K but has a cost of $17K). The increased in
expected profit is $11.5K, which is better than $3K. Therefore, the profit maximizing solution is
to ask for $40K. This outcome is not socially efficient because it results in the technology not
being installed when the damages are $20K, but these damages do merit the installation of the
technology.

(c) Alternatively, the court could decide that the citizens have the right to clean water.
As a starting point, Acme could only operate if it installs the technology. However,
the court would allow the CFA (as the bargaining agent of the people) to decide on a
take-it-or-leave-it offer of a payment from Acme to the CFA that would allow Acme
to pollute. In this case, the CFA has the property right and the bargaining power. Is
 there any acceptable transfer that the CFA would be willing to accept that would
allow Acme to pollute the lake? Does this assignment of property rights and
bargaining power result in the efficient outcome?

ANSWER: The CFA would ask for a minimum of $20K or $40K depending on which damage
figure is correct. Presumably, the CFA knows the damage (unlike Acme that only has a
probability distribution). Acme would prefer to just pay the $17K to install the technology.
Thus, there are no acceptable transfers that would allow Acme to pollute the lake. The
technology is always installed, which is the socially efficient technology.

(d) How would you answer (a), (b) and (c) if the new technology cost $25K rather than
$17K?

ANSWER: (a): Now installing the technology is only socially efficient when the damages are
$40K. If the damage is only $20K, then the cost of remediation exceeds the benefit of
eliminating the pollution.

(b): Acme would still maximize profit by asking for $40K. The CFA would only accept if the
damage is $40K. The technology is only installed when damages are high, which is socially
efficient.

(c): With the higher cost of abatement, the CFA could ask for a payment of (just under) $25K
when damages are only $20K. Acme would prefer to make the transfer over installing the
technology. If the damages are $40K, then no bargain will be reached, and Acme will install the
technology. This outcome is socially efficient.

EXTRA QUESTION AND EXPLANATION: As with most applications of Coase bargaining, in

comparing the outcomes with different property rights and bargaining rules, the resulting
distribution of wealth depends on who has the property rights and bargaining power. However,
unlike the standard example of Coasian bargaining, in this example the efficiency of the outcome
depends on property rights and bargaining power. What are the implications of this example for
the assignment of bargaining power and property rights? That is, why does efficiency depend on
bargaining power and property rights?

ANSWER: The glitch in this example relative to the standard Coase assumptions is that
information is not perfect. Acme does not know how much damage the pollution will cause the
CFA. The one time that bargaining fails to get the efficient outcome is when the technology
costs $17K and the damages are $20K but Acme makes a take-it-or-leave-it offer. If CFA has
the bargaining power (i.e., gets to make the offer) or the technology costs $25K (regardless of
who makes the offer), then the outcome is socially efficient. If further rounds of bargaining are
possible, then Acme would start by asking for $40K, but then would lower the price if the CFA
rejected the offer. (Of course, the CFA might then just reject the offer of $40K because it thinks
that Acme will take a rejection as a sign that the damages are only $20K.) The implication for
the assignment of property rights is that when there is asymmetric information about costs and
benefits, it can be beneficial to assign the property rights to the party with better information
about costs and benefits.
3. Sunshine in Miami Beach

I will distribute the decision in Fontainebleau Hotel Corp v. 4525, Inc. 114 So. 2d 357 (Fla.
Dist. Ct. App. 1959) so you can have details of this story. The short version is that the
Fontainebleau Hotel and the Eden Roc Hotels were neighbors in Miami Beach. The
Fontainebleau was about to build a 14-story expansion that would block the sun on the beach
and pool area of the Eden Roc. The owners of the Eden Roc sued for an injunction that
would stop the development. The lower court granted the injunction relying on the principle
of sic utere tuo ut alienum non laedas, translated as “use your property in such a way that
you do not damage others”. The appeals court reversed the injunction with the reasoning that
the previous decision took too broad of an interpretation of this principle. The question
becomes whether a landowner has a legal right to the free flow of light and air from
adjoining land.

(A) According to the Coase theorem, do you think whether the new 14-story tower will be
built depends on how the court rules? Why or why not?

ANSWER: The answer depends on a few “preconditions” of the Coase Theorem. If transactions
costs and bargaining costs are zero, property rights are well defined, information is known
(essentially part of zero transaction / bargaining costs) and the allocation of property rights does
not create wealth effects, then the allocation of initial allocation of property rights will not affect
the eventual outcome in terms of how property is used. The court ruling should resolve questions
about the definition of property rights so the issue comes down to the other issues. Given that
there are only two parties that seem relatively well-informed about the hotel beach in Miami
Beach, it seems like negotiations could lead to the same result regardless of how the court rules.
The court ruling will determine the allocation between the two parties (see the negotiation stories
in the parts below).

One possible human factor that could affect the negotiations is the personalities involved. Spite
might come into play. If the neighbors do not like each other, then negotiations might breakdown
such that the court’s ruling makes one outcome more likely than the other. For example, if Eden
Roc wins, the owner might rebuff even very large financial offers to allow the Fontainebleau to
build the tower.

The last remaining issue to consider is whether wealth effects might come into play in this
example. Typically, in business-to-business negotiations, we don’t think of income or wealth
effects mattering since the level of initial wealth does not affect the profitability of investment
decisions. However, if these businesses are owned by families or small groups, then wealth
effects might matter. Suppose Eden Roc is a relatively small enterprise that faces financial
limitations. If the court sides with Fontainebleau, Eden Roc may not have the money to pay
Fontainebleau the required side payment to prevent the tower from being built. However, if Eden
Roc prevails in court, it might be reluctant to sell the right for cash because it feels that it
property is now worth more than they originally thought; in this case, the outcome might depend
on the court ruling.
 (B) Suppose the court had ruled in favor of Eden Roc by enjoining the Fontainebleau from
building the tower. What recourse might the Fontainebleau have had if it still wanted to
build the tower?

ANSWER: If Eden Roc won the case, the Fontainebleau’s recourse would have been to offer a
cash payment to Eden Roc so that they would permit Fontainebleau to build the tower. An
extreme version of this strategy would be for Fontainebleau to buy Eden Roc out as a corporate
entity. Many people talked about appeals, etc., but I had in mind a definitive outcome. They
could also seek political remedies, but I was mostly interested in fleshing out the Coase story.

(C) Given that the court ruled in favor of the Fontainebleau, how might the owners of the
Eden Roc respond if they want to stop the expansion?

ANSWER: Once Fontainebleau had the go ahead from the court to build the new tower, Eden
Roc’s owners could have tried a negotiation. Of course, by having the right to build,
Fontainebleau would hold the cards in this negotiation and have a much stronger bargaining
position. In the extreme, Eden Roc could buy the Fontainebleau so that the properties were
owned by a single owner (as in part B). A single owner should be able to internalize the issues
created by conflicting uses of property. (See also the end of the answer to part B.)