**Question**

Problem – More Property Rights

Consider the following situation involving two neighboring firms, Sunny Days Daycare and Hoss Rocket’s Chemical Weapons Incinerating. The children of Sunny Days prefer to pass the

day playing outside, but the emissions from Hoss Rocket’s incinerator are so incredibly toxic that breathing the air within a three-mile radius of the facility causes instant, irreversible lung damage. The two firms are located a mile apart, and far from any other firms. As a result, whenever Hoss Rocket operates (which he does, 5 days a week, during normal business hours), Sunny Days must keep its children indoors. Suppose the parents of children attending Sunny Days are willing to pay $24 per day for daycare when their children can play outside, but only $8 per day when the children have to remain indoors (assume there are competing daycare providers located close enough that Sunny Days has to lower its price for the indoor-only option). Assume, for simplicity, that Sunny Days has zero costs, so its revenue equals profit. Hoss Rocket’s profits, if he’s allowed to pollute, are $200,000 per year.

Sunny Days decides to take Hoss to court. There are two alternatives for solving this externality problem. First, Hoss Rocket can install filters on its smokestacks, reducing harmful emissions to zero. Installing filters costs $100,000. Second, Sunny Days can put a glass dome over its outdoor playground, allowing children all the benefits of being outdoors, without the ill effects of breathing mustard gas. Doming the playground will cost $20,000. When either the filters or the dome is implemented, parents are again willing to pay $24 per day to Sunny Days.

Assume that whether or not the externality is addressed, Sunny Days serves 10 children, 5 days a week for 50 weeks a year. Answer the following questions about possible outcomes

from trial, given the size of transaction costs.

1. Calculate Sunny Days’s profits and Hoss Rocket’s profits, assuming neither firm takes action to address the externality.

2. Calculate both firms’ profits, assuming the daycare center installs the dome.

3. Calculate both firms’ profits, assuming Hoss Rocket installs filters.

4. Calculate both firms’ profits, when they both address the externality (i.e. – Sunny Days builds the dome, and Hoss Rocket installs lters). Finally, set up a profits matrix.

5. What is the socially efficient outcome? Assuming the firms cannot negotiate, what legal ruling would induce this outcome?

6. Now assume the parties that the parties can negotiate (i.e. – transaction costs are low). Fill in the table below.

7. What are each of the parties’ threat values, under each of the three possible legal rulings (i.e. – polluter’s rights, Sunny Days awarded damages, Sunny Days awarded an injunction)?

8. Assuming cooperation is possible, what is true about the sum of the parties’ payoffs under all three legal rulings? What fundamental theorem does your answer support?

9. Which of the three legal ruling does Sunny Days prefer (polluter’s rights, damages or injunction), given the firms can cooperate? Is this true in general, or true only in this particular example? Explain your reasoning.

10. Assuming again that the parties cannot bargain with one another, and also that the law believes Sunny Days has the right to make pro ts free from Hoss Rocket’ s interference, what remedy should the court prescribe, given that the court is also concerned about efficiency?