A farm can produce up to 10 tons of corn p.a. which the farmer sells for $1000 per ton. The cost of running the farm is $8000 p.a. A rancher intends to set up a cattle operation on the land she owns next door. The cattle operation will earn $4000, but the cows will wander over to the farm, trample the corn and reduce output by one ton. It costs $1500 p.a. to build a fence that keep the cattle on the ranch. Assume the rancher and the farmer are able to negotiate, as required by the Coase theorem.

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First, I will restate the scenario and all answer choices to ensure clarity.
- Scenario: A farm can produce up to 10 tons of corn per year, sold at $1000 per ton. The farm’s annual cost is $8000. A neighboring rancher plans cattle, which would earn $4000, but will cause cows to wander onto the farm and reduce corn output by 1 ton. A fence to keep cattle on the ranch costs $1500 per year. The rancher and farmer can negotiate as per the Coase theorem.
- Answer options:
  1) If the court says the rancher is responsible for damage caused by his cows, the rancher will build a fence.
  2) No matter what the court says, the cattle will end up wandering onto the farm, destroying some of the corn.
  3) No matter what the court says, the rancher will give up.
  4) If the court says the rancher can do as he likes without bearing the cost, the farmer will build a fence.

Now, I’ll analyze each option in turn and explain why it is right or wrong.

Option 1: If the court assigns liability to the rancher, the rancher will build a fence.
- Why this could be plausible: Under an assignment of liability, the rancher might invest in a fence to avoid paying damages, since building the fence can be a way to prevent further losses and reduce liability costs.
- Why this is not the best answer here: We must compare costs and benefits. The fence costs $1500 per year. Preventing the 1-ton corn loss saves 1,000 in revenue (10 tons at $1000 each minus the $8000 cost). The net effect of erecting the fence is −$1500 (cost) + $1000 (avoided loss) = −$500 in annual welfare from the fence, ignoring any changes in the rancher’s own profits. Since the total social benefit is negative, the efficient outcome would be not to build the fence. Therefore, this option describes a potentially suboptimal move, not the inevitable or necessarily efficient outcome under Coase bargaining in this setup.

Option 2: No matter what the court says, the cattle will end up wandering onto the farm, destroying some of the corn.
- Why this is correct: The key comparison is the social value of preventing the damage versus the cost of the fence. Preventing the loss costs $1500, while the value of the corn saved is only $1000. The net social benefit of building the fence is −$500 per year, so the efficient outcome is not to build the fence and allow the wandering to occur, resulting in the 1-ton loss valued at $1000 of corn. Since the fence is not socially worthwhile, and assuming transaction costs and negotiation do not tilt the balance in favor of prevention, the cattle wandering becomes the likely outcome even with bargaining possibilities. Thus, the statement that the cattle will wander regardless of court rulings aligns with the cost-benefit calculation in this setup.

Option 3: No matter what the court says, the rancher will give up.
- Why this is not correct: This is a strong behavioral claim with no support from the numerical data. The rancher gains $4000 from cattle, so there is a clear incentive to invest in activities on the ranch. Saying the rancher will give up ignores the positive payoff and the potential to prevent other losses via fencing or renegotiation. The Coase framework suggests bargaining could occur, not inevitability of giving up.

Option 4: If the court says the rancher can do as he likes without bearing the cost, the farmer will build a fence.
- Why this is not correct: If the rancher has freedom to act without bearing costs, the farmer would have no direct incentive to fund a fence unless compelled by the court or through a negotiated transfer. This option asserts the farmer would unilaterally build the fence, which contradicts the typical Coase bargaining setup where the party with the liability or the party affected would negotiate compensation or property-right transfers. It also ignores the fact that the fence cost is borne by whoever pays for it in a negotiated agreement; the option describes a unilateral, unlikely move under standard Coase-type negotiations.

In summary, considering the cost of the fence versus the value of the corn protected (1000) and the fence cost (1500), the net social effect of building the fence is negative. With these numbers, the publicly optimal (efficient) outcome would be to accept the wandering and the 1-ton loss in corn, rather than incur a higher cost to prevent it. Therefore, option 2 correctly captures the outcome under these economic parameters.

IFEPIA7022_001_2025_3 - Economics of Finance EOF Midterm

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