Steven and Joe are roommates in a cramped apartment, and they’re increasingly getting on each others’ nerves. Steven is vegan, a smoker, and extremely hygenic. Joe is an omnivorous asthmatic. The two ended up as roommates only because the supply of similar-quality twobedroom apartments in Manhattan is extremely tight, and neither is wealthy enough to afford to live without a roommate. Unable to reconcile their differences, they have hired a roommate counseler to recommend ways of ameliorating their disputes. Here are the facts.

Joe experiences difficulty breathing when Steven smokes indoors. Joe, the counselor finds, places a value of $20,000 on having healthy lungs. Steven, meanwhile, is of frail constitution and prefers not to have to smoke outside on the fire escape for fear of catching a cold in the winter. Steven values the freedom to smoke indoors at $12,000.

There are two, and only two potential solutions to this externality problem. Either party could break the lease and move out. The leaver would be responsible for his share of the rest of the year’s rent ($15, 000) if he didn’t find a substitute roommate, and $0 if he did. Whoever moves out, the probability that he will be able to find a replacement roommate is 0.8. Moving out also imposes (for certain) relocation and apartment search costs of $10, 000 on the mover. Alternatively, the second solution is that the apartment could be subdivided with a wall down the middle and a second kitchen and bathroom installed. Subdivision costs $11, 000 and requires the consent of both roommates. Assume the subdivision would completely eliminate the externality.

a) What are the parties’ threat values if Steven enjoys the legal right to smoke indoors?

b) Same question, but now Joe has the legal right to clean air.

c) Identify the socially efficient solution.

d) Suppose both parties expected a court to rule in favor of Joe, were they to litigate. Write down a model of how their bargaining might proceed under this assumption. Include the threat values, cooperative solution, cooperative surplus, and the surplus’s possible divisions between the two parties

e) Suppose now that transaction costs of bargaining are extremely high. Perhaps the roommate counselor’s rates are excessive, or animosity between Steven and Joe is so great that they cannot sit down at the same table. Suppose, in addition that neither will agree to a subdivision of the apartment, and that the judge is unwilling to impose one. What is the efficient legal ruling in this scenario?