Question

The tire plant discharges pollutants into the local lake during the production process. People who do not drive and do not buy tires are affected by the pollutants since they can no longer swim or fish in the lake.

a. Sketch the marginal private cost and the marginal social cost of tires.

b. Label the market price and quantity of tires.

c. Label the socially efficient level tires.

d. Demonstrate the tax on the tire company the government would have to impose to arrive at the socially efficient level and price for tires.

Answer 1

(a)

Discharge of pollutants cause negative externality in production. This causes external cost which shifts marginal private cost (MPC) to shift leftward to marginal social cost (MSC).

(b)

Market price is P0 and market output is Q0, at intersection of marginal private benefit (MPB) and MPC (point A).

(c)

Socially efficient price is P1 and market output is Q1, at intersection of MPB and MSC (point B).

(d)

Unless internalized, the externality will cause a deadweight loss of area ABC. To ensure efficiency, government has to impose a Pigouvian tax of BD per unit.