Question

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 the efficient outcome? The railroad will purchase the grease for $1.200 and pay the farmer nothing because no crop damage will occur The farmer will incur $1.500 in damages to his crops. The farmer will pay the railroad $1.200 to purchase the grease so that no crop damage will occur. The railroad will continue to operate but will pay the farmer $1,500 in damages

Answer 1

The railroad is not liable for any kind of damage caused to the crops, thus they will not spend any money from their side to prevent the damage . It is the farmers who are willing to stop it as they are facing rhe damage of 1500 dollar, now if the farmers pay 1200 dollars to the railroad which is less than the damaged amount when no precaution is taken from both parties, the railroad will take that 1200 dollars to buy grease so that no crop will be damaged. Thus here the farmers have to pay the cost of the externality either 1500 dollars by not doing anything or 1200 dollar by giving it to the railroad to buy grease as the railroads are not liable for the damage.Thus the efficient outcome is - the farmer will pay 1200 dolaars to the railroad to purchase grease so that no crop damage will occur.