Solved: Suppose Smith owns and works in a bakery

located next
Suppose Smith owns and works in a bakery located next

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 PC = 30 - 0.2QC, while when the
windows are closed, demand is given by PC = 25 - 0.2QC. 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, except 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.

Suppose Smith owns and works in a bakery located next

ANSWER
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