Question

The effect of negative externalities on the optimal quantityof consumption

Consider the market for paper. Suppose that a paper factory dumps toxic waste into a nearby river, creating a negative externality for those living downstream from the factory. Producing an additional ton of paper imposes a constant external cost of $180 per ton. The following graph shows the demand (private value) curve and the supply (private cost) curve for paper.

Use the purple points (diamond symbol) to plot the social cost curve when the external cost is $180 per ton

The market equilibrium quantity is [1,5, 2, 2.5,3,3.5,4,4.5,5,5] tons of paper, but the socially optimal quantity of paper production is [1,5, 2, 2.5,3,3.5,4,4.5,5,5]   tons.

To create an incentive for the firm to produce the socially optimal quantity of paper, the government could impose a[Tax /Subsidy] of _____per ton of paper.

Answer 1

(1) Social cost curve will lie above the Supply curve by $180 at every output level.

(2) Market equilibrium quantity is 4.5 tons (at intersection of demand and supply curves) but socially optimal quantity is 3.5 tons (at intersection of demand and social cost curves).

(3) government could impose a Tax of $180 per ton (= unit external cost).