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 farmer has the right to compensation for any damage that his crops suffer. Assume that there are no transaction costs. Which of the following characterizes the 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 is for the railroad to purchase the grease for $1,200, preventing the $1,500 in damages to the farmer's crops. This solution minimizes the total cost of the externality.

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