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
establishment.
(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.
