Question 1 of 4

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A local town is under pressure from voters to close a polluting factory. The head of the homeowner’s organization argues that the pollution is a menace, and if the full external costs of the pollution were included, the factory would be unprofitable. The homeowners calculate that the pollution generates an external cost of $3,000,000 per year in medical bills and $1,000,000 per year in suppressed property values (the difference in home prices with and without the pollution). The factory, on its books, makes a profit of $5,000,000 per year.

What is the external cost of the pollution?

$2,000,000

$4,000,000

$1,000,000

$3,000,000

Correct! External costs of pollution are those costs that are not incurred by the polluter, or alternatively, incurred by bystanders (homeowners in this case). In this example, external costs equal the sum of $3,000,000 in medical bills and $1,000,000 in suppressed property values.

Sorry! Are you considering all of the costs imposed by the polluting factory on homeowners? To review how to calculate external costs, please see the section “External Costs, External Benefits, and Efficiency.”

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If the factory is forced to consider the total social costs of pollution, would it be profitable?

Yes, but it would reduce profits to $3,000,000.

Yes, but it would reduce profits to $1,000,000.

Yes, and profits would not change from $4,000,000.

No, it would have to close.

Correct! It currently has $5,000,000 in profit but after paying the external costs of $4,000,000, the firm would see profits reduced to $1,000,000.

Sorry! Think about the factory’s current level of profit and how that would change if it were forced to consider the total social costs of pollution. To review taxes, please see the section “Government Solutions to Externality Problems.”

How much could the town tax the factory before profits became zero?

$5,000,000

$4,000,000

$3,000,000

$1,000,000

Correct! Given that factory profits are currently at $5,000,000, then a tax of $5,000,000 would lower those profits to zero.

Sorry! Think about the factory’s current level of profit and what it would take to lower that value down to zero. To review taxes, please see the section “Government Solutions to Externality Problems.”

What does the Coase theorem suggest about negotiations between the town and the factory?

The Coase theorem would suggest that if property rights are clearly defined with low transaction costs, a command and control solution would lead to the best outcome for the town and polluter.

The Coase theorem would suggest that if property rights are poorly defined with high transaction costs, a negotiated settlement would lead to the best outcome for the town and polluter.

The Coase theorem would suggest that if property rights are clearly defined with low transaction costs, a negotiated settlement would lead to the worst outcome for the town and polluter.

The Coase theorem would suggest that if property rights are clearly defined and there are low transactions cost, a negotiated settlement would lead to the best outcome for the town and polluter.

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