Consider a public resource that is required for the production process of a firm, but its use destroys it. The profit of the firm from the usage of this resource will be 200$, but it also decreases the utility of the public by 100$. The government considers two options over the ownership rights of this resource in order to maximize welfare.

Question

BlackTom AI · Accepted Answer

Let’s restate the scenario to have a clear starting point: a public resource required for production is destructively used; the firm earns a profit of $200 from using it, while the public’s utility falls by $100. The government is weighing ownership and transfer arrangements to maximize welfare across the two parties.

Option 1: The government grants the firm the ownership rights, but allows the public to pay an aggregable compensation to the firm for avoiding its usage. This option describes a system where the firm owns the resource and the public pays the firm to refrain from using it. This structure is internally inconsistent with standard welfare-maximizing mechanisms for a depletable public good: it creates incentives to reduce usage but assigns ownership and payments in a way that does not clearly align costs and benefits between the public and the firm. In practice, it could distort incentives, fail to capture the external harm to the public, and does not transparently solve the depletion externality.

Option 2: All answers are wrong. This would be true only if every other option were incorrect. Given the subsequent evaluation, there is at least one viable option that better aligns incentives and welfare, so declaring all answers wrong would be inaccurate.

Option 3: The government grants the public the ownership rights, but allows the firm to pay an aggregable compensation to the public for the use of this resource. This structure directly targets the externality by transferring ownership to the entity that bears the external cost (the public) and enabling the firm to compensate the public for the resource’s use. The compensatory payment to the public internalizes part of the social cost (the $100 reduction in public utility) and can incentivize efficient usage levels. In welfare terms, it aligns private incentives with social welfare by creating a price on the resource that reflects its depletion impact, while ownership by the public ensures the resource remains under the control of those affected by its use.

Option 4: Both answers are right. This would require that both Option 1 and Option 3 be correct. Since Option 1 is not a coherent or welfare-enhancing approach given the externality and ownership considerations, this combined claim is inaccurate.

In summary, Option 3 best aligns incentives and addresses the externality by transferring ownership to the public and permitting a compensatory payment from the firm for use. The other options fail to properly internalize the social costs or rely on inconsistent ownership and payment structures, which undermines welfare maximization.

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