Suppose that Company A's railroad cars pass through Farmer B's corn fields. The railroad causes an externality to the farmer because the railroad cars emit sparks that cause $1,500 in damage to the farmer's crops. There is a special soy-based grease that the railroad could purchase that would eliminate the damaging sparks. The grease costs $1,200. Suppose that the farmer has the right to compensation for any damage that his crops suffer. Assume that there are no transaction costs. Which of the following characterizes the efficient outcome?

a) the railroad will continue to operate but will pay the farmer $1,500 in damages
b) the railroad will purchase the grease for $1,2000 and pay the farmer nothing because no crop damage will occur
c) the farmer will incur $1,500 in damages to his crops
d) the farmer will pay te railroad $1,200 to purchase the grease so that no crop damage will occur

Now provided that if company purchases grease costs $1,200 will be the expense but this will help company save net of $300 i.e. $1,500 crop reimbursement - $1,200 for grease equipment.

Therefore as for the efficient outcome for both farmer and company this is best appropriate to be chosen as in this no loss to farmer will occur and also the compensation cost of $1,500 will not be incurred to company rather only one time $1,200 will be paid.

b) the railroad will purchase the grease for $1,200 and pay the farmer nothing because no crop damage will occur