The Coase Theorem is often applied in court cases where the parties seek to clarify who has the right to do what in the presence of externalities. Consider again (as in the text discussion) the case of the addition to my house that will then cast a shadow on your swimming pool. Suppose that my benefit from the addition is b, and the cost you incur from my shadow is c. suppose throughout this exercise those transactions costs are zero.
A. In this part of the exercise, suppose that you and i both know what b and c are.
(a) If we both know b and c, why don’t we just get together and try to settle the matter over coffee rather than ending up in court?
(b) If the judge (who has to decide whether I have a right to build my addition) also knows b and c, propose a sensible and efficient rule for him to use to adjudicate the case.
(c) Judges rarely have as much information as plaintiffs and defendants. It is therefore reasonable for the judge to assume that he cannot easily ascertain b and c. suppose he rules in my favor. What does Coase predict will happen?
(d)What if he instead rules in your favor?
(e) In what sense will the outcome always be the same as it was in part (b) —and in what sense will it not?
B. Next, assume that I know b and you know c but I do not know c and you do not know b.
(a) Suppose the judge rules in your favor, and I now attempt to convince you to let me build the addition anyhow. I will come to your house and make an offer based on my belief that your cost is less than  with probability ρ() = /α. What offer will I make?
(b) For what combinations of b and c will the outcome be inefficient?
(c) Suppose instead that the judge ruled in my favor. You therefore come to my house to convince me not to build the addition even though I now have the right to do so. You will make me an offer based on your belief that my benefit from the addition is less than or equal to  with probability δ() = /β. What offer will you make?
(d) For what combinations of b and c will the outcome be inefficient?
(e) Explain how the cost of obtaining information might be considered a transactions cost—and the results you derived here are therefore consistent with the Coase Theorem.