Problems for Chapter 4


I. Producing steel involves internal costs, such as the time and effort of the steelworkers, and external costs, such as pollution.

A. Briefly explain why it is only the external costs that pose a problem for getting an efficient outcome.

B. Briefly sketch the three alternative approaches to solving that problem that we have considered.

C. For each of the three alternatives, describe a situation where it doesn't work and briefly explain why.


II. I summed up Coase's analysis as consisting of three parts: Nothing works. Everything works. It all depends (on transaction costs). Pick one of the three, and explain that part of the argument in your own words.


III. A factory pollutes a lake which is also used by twenty vacation resorts. It would cost the factory $1,000,000 a year to prevent the pollution. Each resort faces the following alternatives (remember that there are twenty resorts):

a: Operate as a resort on an unpolluted lake, making $100,000/year profit.

b: Operate as a resort on a polluted lake, making $40,000/year profit.

c: Operate as a hunting lodge, making $60,000/year profit, whether or not the lake is polluted


A. What is the efficient solution? (5 points)

The factory should (pollute/not pollute)

The resorts should be operated as (resorts/hunting lodges)


In answering parts B and C, describe first what happens if there is no bargaining between factory and resort owners, and then whether bargaining will change the outcome. Explain briefly.

B. The factory has the right to pollute if it wants to.

C. Any resort can enjoin the pollution, so the factory can only pollute if it has permission from all the resorts.