Question

A number of firms have located in the western portion of a town after single- family residences took up the eastern portion. Each firm produces the same product and in the process emits noxious fumes that adversely affect the residents of the community. a. Why is there an externality created by the firms? b. Do you think that private bargaining can resolve the problem? Explain. c. How might the community determine the efficient level of air quality?

Short answer

The externality is created due to the firms' noxious emissions affecting residents without bearing the cost. While private bargaining could be a potential solution, the number of parties and complexity of defining property rights over air quality could make this ineffective. The community could determine the efficient air quality level by performing a Cost-Benefit Analysis, balancing the cost of pollution remediation by the firms and the health and environmental benefits to residents.

Step-by-step solution

Reason for Externality Creation

The externality is created by the firms' activity of producing products that emit noxious fumes. This production process consequently leads to air pollution which negatively impacts the residents, however, the firms do not bear the cost of these negative impacts. This situation is a classic example of a negative externality, where the cost of production is not fully reflected in the price of the product.

Potential of Private Bargaining

The Coase theorem states that private bargaining can indeed solve externality problems, given that transaction costs are low and property rights are clearly defined. However, in this case, the number of firms and residents involved could make negotiation complex and transaction costs could be high. Moreover, defining property rights over air quality can be challenging. Therefore, private bargaining may not effectively resolve the problem here.

Determining Efficient Level of Air Quality

The community can determine the efficient level of air quality by balancing the marginal social cost with the marginal social benefit of an action. They may conduct a Cost-Benefit Analysis (CBA) by taking into account the cost of remediating the pollution (borne by the firms) and the benefits, which are improved health and environmental quality (accrued to the residents). Decision to determine the right level of air quality should be made at the point where marginal social cost equals marginal social benefit.