Question 1:

In each of the following situations, discuss whether free markets are likely to provide Pareto-optimal levels of the goods, or whether a market failure distorts the markets.

(a) Although a restaurant has a separate smoking section, the smoke from that section spreads to the nonsmoking part of the dining area. As a result, some of the nonsmokers leave before they have finished their dinners.

(b) A restaurant owner decides on his own to separate, both physically and through ventilation systems, the smoking and nonsmoking sections of his restaurant. Both smokers and nonsmokers find the arrangement acceptable.

(c) Radon, a naturally occurring gas, increases the risk of cancer in poorly ventilated basements in areas with particular geologic characteristics. For purposes of this question, assume that radon affects only homeowners living in the house, and the homeowner can easily find out radon levels in the house. Ventilating the radon out of a home costs about $1000.

(d) Suppose now that, if a homeowner takes care of the radon in his home, he may reduce radon levels in neighbors' houses as well. How does that change your answer in (c)?

Question 2:

Are the following decisions Pareto improving? Pareto optimal? Explain why or why not.

(a) The restaurant owner in 1(b) spent $10,000 to install the separate ventilation systems but felt it was worth it in terms of improved customer satisfaction and resulting increase in visits.

(b) The homeowner in 1(d) decided not to install a radon ventilation system, because he was unwilling to pay more than $500 (his valuation of the additional risk due to radon exposure) to eliminate the radon in his house.

(c) Because 10 neighbors of the homeowner in 2(c) would benefit $100 each from reduced health risks due to radon if the homeowner put in the ventilation system, the homeowners' association for the neighborhood required the homeowner to install the abatement system.