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Noise and smell externalities

Suppose Smith owns and works in a bakery located next to an
outdoor cafe owned by Jones. The patrons of the outdoor cafe like
the smell that emanates from the bakery. When Smith leaves his
windows open, the cafe faces the demand curve P=30-0.2Q, while
when the windows are closed, demand is given by P=25-0.2Q.
However, Smith doesn't like the street noise he hears when his
windows are open, and in particular, the disutility he receives has a
monetary value of 5. Assume that the cafe has a constant marginal
cost of 10, and that integration (merger) is not a possibility because
each owner greatly enjoys owning and operating his own

(a) In the absence of a contract between the parties, do the firms behave
in an efficient fashion? If not, describe the range of contracts that
might emerge in response to the externality problem present in the
environment. In answering this question, assume Smith understands
how the bakery odor affects demand at the cafe, and Jones knows
how much Smith dislikes street noise.

(b) Suppose now everything is the same as above, expect that given the
current seating arrangement in the cafe, the cafe does not face a
higher demand when the bakery windows are open. To realize this
higher demand, Jones needs to make a sunk investment of 50, which
moves the tables closer to the bakery. Is it wise for Jones to make
this investment prior to Smith and Jones signing a contract? Explain.

(c) Go back to the initial setup, but now assume that Smith's disutility
from street noise equals 50 rather than 5. Further, suppose that prior
to the parties agreeing on a contract Jones becomes the mayor and
grants to himself the property rights concerning whether the bakery
windows are left open or closed. Does this have an effect on whether
the parties reach an efficient outcome? Explain.

Solution Preview

a. Notice that the prices given by the demand curves differ by only five (30 vs 25). This means that the price of each item sold by the cafe declines by 5 when the windows are closed. The bakery owner suffers only the loss of 5 dollars once when the windows are open. As long as the cafe is selling more than one unit, the efficient outcome is to leave the windows open. The cafe owner benefits more than the bakery owner suffers. However, ...

Solution Summary

Finding the socially optimal production of bakery smells and street noise