Cleantown and Grimyville are identical except for the inferior air quality in Grimyville. All potential residents have identical tastes. Apartments in Cleantown rent for $400 per month. The cost of breathing Grimyville air is $75 per month. The quantity of apartments in each town is fixed.
(i) Explain why an apartment in Grimyville must rent for $325 per month.
(ii) Consider the social gain created by Grimyville apartments. How is this social gain divided between the residents and the landlords?
(iii) Suppose that the air in Grimyville is brought up to Cleantown standards. Who benefits from the cleaner air?
(i) Rent must be lower in Grimyville to compensate residents for the poorer air quality. Further, the rent in Grimyville must be just lower enough to make people indifferent between the two towns. If people were not indifferent, then there would be migration between the two towns and the rents would adjust until the people were indifferent. Thus, rent in Grimyville must equal the rent in Cleantown minus the cost of breathing Grimyville air. Grimyville apartments must rent for $400 - $75 = $325 per month.
(ii) Residents receive no consumers' surplus from renting Grimyville apartments, because they are indifferent between living in Cleantown and living in Grimyville. Residents' demand curve for Grimyville apartments is horizontal at the price of $325 per month. Thus, Grimyville landlords receive all of the social gain created by Grimyville apartments.
(iii) The cleaner air makes Grimyville apartments indistinguishable from Cleantown apartments, so Grimyville apartments must now rent for $400 per month. Any benefits that Grimyville residents receive from cleaner air are offset by higher rents. These higher rents are surplus value for Grimyville landlords, so they are the only ones who benefit from the cleaner air.
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