Question

suppose that both the chemical and eyeglass industries in new jersey are perfectly competitive. emissions from the chemical industry, however, leaves particles on the grinding equipment used for making glasses that must constantly be removed. hence chemical production raises the cost to produce eyeglasses.

question:

using graphical analysis, show why market forces in these two markets will not achieve efficient equilibrium prices and quantities exchanged in the market.

Answer 1

This is an example of negative externalities. Firm does not internalize cost of emission. Demand and supply forces external cost associated with output of chemical and eyeglass. Hence, firm tends to overproduce.

Following is graphical presentation:

In above graph, equilibrium quantity and prices are decided where demand and supply are equal. Supply curve which is Marginal cost of firm initially does not include Marginal external cost to society. Thus, firm tends to overpoduce.

Supply curve with externalities denotes the Social marginal cost (SMC) and socially optimal output is decided where SMC or supply curve with externalities equals demand curve.

Hence, optimal output is Qs and price Ps.