Imagine that there are two firms E and F. Firm E imposes a negative externality
ID: 1125571 • Letter: I
Question
Imagine that there are two firms E and F. Firm E imposes a negative externality of firm F by polluting a fresh water lake the two firms use for production. Assume that given the presence of externality the underlying decentralized allocation is inefficient. Assume that the local government tries to restore efficiency by defining property rights over the lake and allowing for trade in clean water contained in the lake. In addition, assume that the local government yields to a pressure from lobbyists and assigns 98% of water to firm E and only 2% to firm F. Can we expect the policy to be effective in restoring efficiency? (a) We cannot tell as the exact extent of the externality is not known to the government (b)No, as the initial distribution of water is highly unfair (c) Yes
Explanation / Answer
The corect answer should be option (a) We cannot tell as the exact extent of the externality is not known to the government.
There is no information given about the authority (property right) of which firm is more on the fresh water body. no information on what extend the negative externality is being created. There is no information about the size & scale of business of each firm. If firm E is a very large player or a small payer, it wll depend on this also. So on whar basis is ratio of 98:2 is used is not clear at all. it is an ambigous situation hence we cant be clear on the policy taken up by the government.