Suppose that Company A's railroad cars pass through Farmer B's corn fields. The railroad causes an externality to the farmer because the railroad cars emit sparks that cause $1,500 in damage to the farmer's crops. There is a special soy-based grease that the railroad could purchase that would eliminate the damaging sparks. The grease costs $1,200. Suppose that the railroad is not liable for any damage caused to the crops. Assume that there are no transaction costs. Which of the following characterizes an efficient outcome?
A)The railroad will continue to operate but will pay the farmer $1,500 in damages.
B)The railroad will purchase the grease for $1,200 and pay the farmer nothing because no crop damage will occur.
C)The farmer will incur $1,500 in damages to his crops.
D)The farmer will pay the railroad $1,200 to purchase the grease so that no crop damage will occur.

Question

Quizplus · Accepted Answer

The efficient outcome occurs when the total cost is minimized. Since the grease costs $1,200 and prevents $1,500 in damages, it is efficient for the grease to be used. The farmer can pay the railroad $1,200 to purchase the grease, which is less than the $1,500 damage cost.

Suppose That Company A's Railroad Cars Pass Through Farmer B's