Question

1. Consider a firm that manufactures dyed textiles. The firm incurs a marginal cost of MC = 2Q. Suppose that for every textile produced, there is an externality cost of 12 (from dyes being leaked into the water). So the true social marginal cost of widget production is MC = 2Q + 12. Imagine that the demand curve for textiles is given by QD = 30-P.

(a) Imagine that the government taxes consumers $12 per widget purchased. What does the demand curve become? Assume firms do not take the externality into account. Show that the equilibrium quantity will now be the same

(b) Now consider an alternate scenario. Everything remains the same in the problem as described above, except the externality cost. Instead of an externality cost, there is an externality benefit. Strangely enough, each textile produced results in an externality benefit of 12. In other words, each textile produced helps purify the water supply. If firms don’t take this benefit into account, they will now produce too little relative to the optimal level. Explain why.

Answer 1