Applying the Coase theorem to externalities

    Situation: Sparks from a train passing through a farming area cause $50,000 of damage to adjacent wheat crops.

A. The Pigouvian approach: Impose a $50,000 tax on the emission of sparks.
    According to Ronald Coase, the Pigouvian approach to externalities interferes with the process of discovering the combination of adjustments by all parties that maximizes social welfare.

B. The Coasian approach

    Coase theorem: Externalities get handled efficiently as long as property rights are clearly assigned and transaction costs (TrC) are negligible.
    Key terms:
    (1) Property right: an entitlement to pursue an activity even if it imposes costs on others.
    (2) Transaction costs (TrC): the costs of utilizing markets (organizing, acquiring information, bargaining, etc.)

    Additional information:
    (1) The railroad can prevent crop damage by installing spark arrestors on the train for $40,000.
            Question (1): With the $50K Pigouvian tax, will the RR install the spark arrestors? (Y?N): _________
    (2) The farmers can avoid crop damage by switching production to clover which costs $30,000 in forgone profits.
            Question (2): With the $50,000 Pigouvian tax, will the farmers switch to clover? (Y/N) _________

Based on the table above:
    i. Which cell results if there is a Pigouvian tax of $50,000 on spark emissions? _________
    ii. Which cell corresponds to the most efficient (lowest cost) combination of options? _________
    iii. How large is the potential gain if the parties move from cell i to cell ii? $_________ (Note: this is the potential gain from bargaining.)

Applying the Coase theorem: