LS 145 Disc_Week 3_Handout_solved

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LS 145 Discussion Section, Fall 2023, Week 3 Quiz 4 Review GSI: Cristina Violante 1 Consider this scenario: Alex runs a factory directly upstream from Brody’s sunflower farm. Alex’s factory dumps chemical waste into the stream that irrigates Brody’s sunflowers, and as a result, some of the sunflower crop is damaged. Assume no one and nothing else is affected by the chemical waste except for the sunflowers. Alex could switch their factory materials to use green products for $2000, or Brody could install a water purification device in their irrigation system for $1000. If either party does one of these things, the sunflowers will no longer be affected. If neither party takes action, Brody will lose $1500 in profits from his sunflower farm. Consider the two following possible legal rules: (1) The law gives Brody the right to grow his sunflowers, free from pollution. (2) The law gives Alex the right to dump the chemicals into the river. 1. If transaction costs are zero, what will be the outcome under either legal rule, and why? Answer Under (1), Alex will pay Brody to install the water purification device, because he’d rather pay that ($1000, plus part of the cooperative surplus) than the $1500 he would otherwise have to pay in damages. Under (2), Brody will pay to install the purification device on his own. He’d rather pay $1000 to install it than lose $1500 in profits. 2. What are the minimum and maximum amounts that Alex would pay Brody to install a water purifier? Why? Answer The minimum Brody would accept to install is $1000, because that is the price of the system, and the most Alex would offer is $1500, because that is the amount he would otherwise be liable for in damages (in other words, these are their threat values). Minimum = $1000 ; maximum = $1500 . 3. What is the cooperative surplus generated by the Coasean bargain between Alex and Brody? Answer Cooperative surplus (CS) = value generated by A and B cooperating. In this case, $1500-$1000 = $500 in CS.

LS 145 Discussion Section, Fall 2023, Week 3 Quiz 4 Review GSI: Cristina Violante 2 4. If the cooperative surplus is split 50/50, how much would Alex pay Brody to install the water purifier? Answer $1000 to install the purifier + .5($500 cooperative surplus) = $1250 For questions 5-8, assume transaction costs are $100. 5. What is the outcome under either legal rule, and why? Answer (same as #1, above) Under (1), Alex will pay Brody to install the water purification device, because he’d rather pay that ($1000, plus $100 transaction costs, plus part of the cooperative surplus) than the $1500 he would otherwise have to pay in damages. Under (2), Brody will pay to install the purification device on his own. He’d rather pay $1000 to install it (plus $100 transaction costs) than lose $1500 in profits. 6. What is the cooperative surplus generated by the Coasian bargain between Alex and Brody? Answer $400 (same as above, but minus transaction costs) 7. If the cooperative surplus is split 50/50 and Alex incurs all of the transaction costs, how much would Alex pay Brody to install the water purifier? Answer Instead of $1500 being the maximum amount Alex would pay Brody to install the filtration system, $1400 is now his maximum ($1500 in potential damages - $100 in transaction costs that Alex pays = $1400 max that A would give to B). The cooperative surplus is now $400, between the range of $1000-$1400. If it is split 50/50, then A pays B $1200 to install the system. 8. If the cooperative surplus is split 50/50 and Brody incurs all of the transaction costs, how much would Alex pay Brody to install the water purifier? Answer Instead of $1000 being the minimum that Brody would need to be paid to install the filtration system, $1100 is now B’s minimum ($1000 in filtration system cost + $100 in transaction costs that Brody pays = $1100 min that B would accept from A). The cooperative surplus is again now $400, between the range of $1100-$1500. If it is split 50/50, then A pays B $1300 to install the system.

LS 145 Discussion Section, Fall 2023, Week 3 Quiz 4 Review GSI: Cristina Violante 3 For question 9, assume transaction costs are $600. 9. What is the outcome under either legal rule, and why? Answer (no longer the same as #1 and #5, above) Under (1), Alex will pay no longer Brody to install the water purification device, because he’d rather pay $1500 in damages than $1600 to install the device ($1000 for instillation, plus $600 transaction costs). Under (2), if Brody has to pay transaction costs, he will no longer choose to install the system because it is more expensive to install ($1000 instillation, plus $600 transaction costs) than the lost profits from the pollution ($1500). If he is not responsible for the transaction costs, then he will pay to install the purification system on his own. Finally, under legal rule (1): 10. At what point (dollar amount) will the transaction costs be so great so as to make negotiations between Alex and Brody break down? Why? What does this tell us about the “threshold” of when transaction costs become too high? Answer Negotiations breakdown when transaction costs exceed the cooperative surplus . As we see in questions 1-8, when transaction costs are low (less than the cooperative surplus of $500), the parties are able to negotiate and A is able to pay B to install the purification device. When transaction costs exceed the cooperative surplus and B has the property right, the parties no longer have incentive to negotiate because paying damages becomes cheaper than negotiating to install the device.

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