Economics 229: Law and Economics

Fall 2024
Problem Set #2
Due: Wednesday, October 2, In Class

1. The Case of the Smelly Pigs

As American suburbs sprawl, houses are being built further and further from the city. As
Americans sprawl, farms are growing more and more pigs to feed Americans’ large
appetites. These two forms of expansion can potentially create conflict. The smells
emanating from pig manure can adversely affect property values. In class, we’ve
discussed how the legal system addresses such nuisance externalities. As a starting point,
let’s consider static efficiency.

Little Pigs (LP) is a hog farm. For each pig that it takes to market, it receives a price of
$1,600. The cost of raising pigs is an increasing function of how many pigs LP raises.
Suppose that this cost function can be summarized by C(q) = 100q2, where q is the
number of pigs raised. (It makes the math easier to consider q to be a modest sized
integer; perhaps it would make sense to think about q being expressed in “thousands of
pigs” but the change would just add zeros to the answer.) This cost function implies that
the marginal cost of raising a pig also increases with the quantity; marginal cost can be
expresses as MC(q) = 200q.

Suppose that there are 100 homes in LP’s neighborhood. For the purposes of this
question, we will ignore whether the residents “came to the nuisance.” The important
thing is that the houses exist. The pig smell is worse the larger the farm. In fact, the
smell grows exponentially with the number of pigs. The aggregate damage sustained by
the residents can be expressed as D(q) = 100q2, where q is the number of pigs raised.
This damage function implies that the marginal damage grows with the number of pigs
raised; marginal damage can be expressed as MD(q) = 200q.

The following table summarizes some of the critical information for the story:

Quantity LP’s Cost LP’s MC LP’s Revenue Damage MD

1 100 200 1600 100 200
2 400 400 3200 400 400
3 900 600 4800 900 600
4 1600 800 6400 1600 800
5 2500 1000 8000 2500 1000
6 3600 1200 9600 3600 1200
7 4900 1400 11200 4900 1400
8 6400 1600 12800 6400 1600
9 8100 1800 14400 8100 1800
10 10000 2000 16000 10000 2000
11 12100 2200 17600 12100 2200
12 14400 2400 19200 14400 2400
 (A) Suppose that LP acts selfishly. What number of pigs will it want to take to market?
Explain.

(B) What is the socially efficient outcome in this situation? Explain.

(C) What sorts of mechanisms might facilitate moving to the socially efficient outcome in
this situation? In thinking about solutions, you can assume that the locations of the farm
and houses is fixed (i.e., don’t consider moving people or pigs to other places – though
that might be sensible in the long run). Consider two types of mechanisms and the
challenges associated with each:

1. Private solutions
2. Public solutions (i.e., government policy)

(D) Suppose that LP could reduce the externality from raising pigs by investing in a
more expensive feed stock. This change in diet for the pigs would increase LP’s marginal
cost by $100 per unit of output (i.e., it adds a constant of $100 to marginal cost). To be
precise the cost function with the more expensive food is C(q) = 100q + 100q2, which
means that marginal cost would be MC(q) = 100 + 200q. This change in diet would cut
the damages (both the total damage and the marginal damage at each number of pigs) in
half. The math changes such that D(q) = 50q2 and the MD is 100q. The change in diet
does not affect the price that LP would receive for selling a pig. How would this
possibility affect your answers to parts (A)? How does the possibility of a less smelly diet
for pigs affect your answer to (B) – the socially efficient outcome? What about your
answers to part (C) – how does the possibility of a variety of diets for the pigs affect the
efficacy of both private and public solutions?

2. Bargains

With perfect information, zero transaction costs, and well-established bargaining rights,
Coasian bargaining can lead to efficient solutions regardless of which party has the initial
property right. This question tweaks the assumption about information along with some
limits on the bargaining process to explore how these assumptions may matter for
outcomes.

In producing widgets, Acme Manufacturing generates pollution that it dumps into

Clearwater Lake. While Acme knows that the pollution upsets local citizens who like to
fish, it does not know the extent to the damage. However, the Clearwater Fishing
Association (CFA) represents the interests of the community and knows the value having
a clean lake. For simplicity, assume that there are two possible states of the world: (1) a
low-harm case in which the community suffers $20,000 of harm from the pollution; and
(2) a high-harm case in which the community suffers $40,000 of harm from the pollution.
One way to think of these numbers is, for example, that the community would be
indifferent between having no pollution and having the pollution with $20,000 of
 compensation in the low-harm case. The CFA knows for certain whether the situation has
low or high harm, but it cannot credibly communicate this information to Acme.
However, Acme knows the two possible states of the world but which one is true. Acme
believes that there is 50% probability of each of the possible situations.

Acme could wipe out all pollution by installing a new technology at a cost of $17,000,
while maintaining all the same revenues and costs (e.g., wiping out the pollution will
reduce Acme’s profits by $17K). (You should think of all the costs and benefits as
adding up all the costs and benefits over time.)

(a) When is the new technology socially efficient? Why?

(b) Suppose that a court declares that Acme has the right to pollute the water, and also
gives Acme the power to make a take-it-or-leave-it solicitation of a transfer (i.e., a bribe)
from the CFA in exchange for installing the new technology. That is, Acme can only
make one offer of an amount it would be willing to accept to install the new technology
and the CFA cannot make a counteroffer. In other words, Acme has both the property
right and the bargaining power. What offer could Acme make that would maximize its
expected profit? Does this result in the socially efficient outcome? (Hints: how does
installing the technology affect Acme’s profit? Start by considering what compensation
Acme would ask for if it could condition its offer based on knowing the state of the world
for certain and then think whether one of this offer would be more profitable when the
state of the world is uncertain.)

(c) Alternatively, the court could decide that the citizens have the right to clean water. As
a starting point, the government has a regulation such that Acme can only operate if it
installs the technology. However, the court would allow the CFA (as the bargaining agent
of the people) to decide on a take-it-or-leave-it offer of a payment from Acme to the CFA
that would allow Acme to pollute (i.e., Acme can buy the right to pollute from the CFA).
In this case, the CFA has the property right and the bargaining power. Is there any
acceptable transfer that the CFA would be willing to accept that would allow Acme to
pollute the lake? Does this assignment of property rights and bargaining power result in
the efficient outcome?

(d) How would you answer (a), (b) and (c) if the new technology cost $25K rather than
$17K?

3. Sunshine in Miami Beach

I will distribute the decision in Fontainebleau Hotel Corp v. 4525, Inc. 114 So. 2d 357
(Fla. Dist. Ct. App. 1959) so you can have details of this story. The short version is that
the Fontainebleau Hotel and the Eden Roc Hotels were neighbors in Miami Beach. The
Fontainebleau was about to build a 14-story expansion that would block the sun on the
beach and pool area of the Eden Roc. The owners of the Eden Roc sued for an injunction
that would stop the development. The lower court granted the injunction relying on the
 principle of sic utere tuo ut alienum non laedas, translated as “use your property in such a
way that you do not damage others”. The appeals court reversed the injunction with the
reasoning that the previous decision took too broad of an interpretation of this principle.
The question becomes whether a landowner has a legal right to the free flow of light and
air from adjoining land.

(A) According to the Coase theorem, do you think whether the new 14-story tower will be
built depends on how the court rules? Why or why not?

(B) Suppose the court had ruled in favor of Eden Roc by enjoining the Fontainebleau from
building the tower. What recourse might the Fontainebleau have had if it still wanted to
build the tower?

(C) Given that the court ruled in favor of the Fontainebleau, how might the owners of the
Eden Roc respond if they want to stop the expansion?