Case scenario:
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 P=30-0.2Q, while when the windows are closed, demand is given by P=25-0.2Q. 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, expect 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.