property rights and resource allocation

Solution Preview

This problem is showing you how property rights can affect the allocation of resources. We can use marginal analysis to determine how the railroad will respond to each situation.

1. Assume first that transaction costs are high enough to prevent bargaining between the railway company and the farmers, and that the railway has no legal liability for the crops it destroys.

a. How many round trips per day will the railway schedule? Why? Will it purchase the spark reducing device? Why or why not?
The railroad will schedule trips to the point where MC=MR, but is not higher than MR. This occurs at 3. Profit at this point is $80.

b. What is the market value of the crops that will be harvested each year (that is, grown and not burned) in the land within range of the sparks? Explain.

The market values of all the crops would be $130. However, $55 worth of them were destroyed, bringing the amount to $75. Farmers' profits are -$25.

2. Now, assume that transaction costs are high enough to prevent bargaining, and that the railway is given legal liability for the crops it damages (that is, it must compensate farmers for the market value of crops that are destroyed by fires).

a. How many round trips per day will the railway schedule? Why? Will it purchase the spark reducing device? Why or why not?

Its marginal cost is now the sum of the marginal cost of crops destroyed and its own marginal cost. This makes its marginal cost at three trips per day greater than its marginal revenue. It will reduce its trips to two per day. Total revenue at this point would be $180 - $140 = $40.

If it purchased the spark protector, it could increase its trips to three per day again to obtain MR greater than MC. Its cost at that point would be $220 and its revenue would be $240. This is only a $20 profit. So, it would not purchase the spark ...