You are probably familiar with this type of setup if you have had any introduction to game theory. We take the two

players as making independent, self-interested decisions. The information is common knowledge and each player is

rational and able to predict the other player’s choices.

The payoffs to the players are interdependent. What one player does affects the other player and they each know this.

The players make their decisions in a sequence: Taggart chooses number of tracks and then Coase chooses number of


Accounting and internal control have a role when the players merge to form a single firm. No longer independent

decision-makers, they are bound together in a single firm. The chapter describes a firm as requiring an allocation of

decision rights, performance measures, and reward structure. Internal control is part of the artful allocation and

enforcement of decision rights. Accounting can be part of the process of measuring performance.

See the explanation in the Module 4 lectures for a solution strategy.

Problem statement

Coase Farm grows soybeans near property owned by Taggard Railroad. Taggart can build zero, one, or two railroad

tracks adjacent to Coase Farm, yielding a net present value of $0, $9 million, or $12 million.


Value of Taggard Railroad (in millions) as a Function of

the Number of Train Tracks (before any damages)


Zero tracks $ 0

One track 9

Two tracks 12


Coase Farm can grow soybeans on zero, one, or two fields, yielding a net present vlue of $0, $15 million, or $18 million

before any environmental damages inflicted by Taggart trains. Environmental damages inflicted by Taggart’s trains are

$4 million per field per track. Coase Farm’s payoffs as a function of the number of fields it uses to grow soybeans and the

number of tracks that Taggart builds are shown below.


Value of Coase Farm (in millions) as a Function of the

Number of Fields Planted and the Number of Train Tracks


Zero fields One field Two fields


Zero tracks $0 $15 $18

One track 0 11 10

Two tracks 0 7 2


As an example, the $7 in the prior table is because Coase has one field worth $15 million and experiences two tracks on

the field for a total of $8 million in environmental damage. It is prohibitively expensive for Taggard Railroad and Coase

Farm to enter into a long-term contract regarding either party’s use of its land.


A. Suppose Taggard Railroad cannot be held liable for the damages its tracks inflict on Coase Farm. Show that

Taggart Railroad will build two tracks and Coase Farm will plant soybeans on one field.

B. Suppose Taggard Railroad can be held fully liable for the damages that its tracks inflict on Coase Farm. Show that

Taggart Railroad will build one track and Coase Farm will plant soybeans on two fields.

C. Now suppose Taggart Railroad and Coase Farm merge. Show that the merged firm will build one track and plant

soybeans on one field.

D. What are the implications of the merger for the organizational architecture of the newly merged firm in terms of

decision rights, performance measurement, and employee compensation? In your discussion, pay particular

attention to internal control and accounting.