(a) State the Coase Theorem. Discuss at least two reasons why this private solution to the problem of externalities may fail to apply.

(b) Consider the interactions between a chemical firm situated on the banks of a river and a fishery located downstream from the chemical firm. The chemical firm benefits from polluting the river while the fishery suffers from any pollution of the river. Specifically, let the marginal benefit of pollution C of the chemical firm be MBC = 48 – C, and let the marginal cost of pollution of the fishery be given by MCF = 12 + C. Suppose also that property rights favour the fishery.

(i) What pollution level will the fishery choose in the absence of any bargaining?

(ii) If both parties bargain, what pollution level will emerge as a result of this mutually beneficial bargaining? As an outcome of the bargaining process, who will make a transfer to whom, and what is the minimum required level of transfer? Explain and provide a graphical representation.

Now suppose that the chemical firm does not know the fishery’s true marginal cost curve. Instead, the fishery persuades the chemical firm that its marginal cost of pollution is MCF = 12 + 2C rather than the true curve (given by MCF = 12 + C). Property rights favour the fishery and bargaining takes place accordingly.

(iii) What pollution level will be chosen through bargaining now? And what is the minimum required level of transfer? Explain and provide a graphical representation.

(iv) Does the fishery have an incentive to misrepresent the position of its marginal cost curve? If so, what is the gain to the fishery from misrepresenting the marginal cost curve when the minimum transfer identified in (c)(i) is paid? What is the magnitude of the inefficiency of the Coasian solution when the fishery misrepresents its marginal cost curve?