Question

Consider the market for steel. Suppose that a steel manufacturing plant dumps toxic waste into a nearby river, creating a negative externality for those living downstream from the plant. Producing an additional ton of steel imposes a constant external cost of $330 per ton. The following graph shows the demand (private value) curve and the supply (private cost) curve for steel.

Use the purple points (diamond symbol) to plot the social cost curve when the external cost is $330 per ton 1100 Social Cost Supply (Private Cost) O 440 O Demand 330 (Private Value) 110 QUANTITY (Tons of steel) The market equilibrium quantity is tons of steel, but the socially optimal quantity of steel production is ? tons To create an incentive for the firm to produce the socially optimal quantity of steel, the government could impose a of per ton of steel

Answer 1

The social and private costs at the different level of outputs are given as follows:

Unit	Private cost	Social cost (Private cost + 330)
1	55	385
2	165	495
3	220	550
4	330	660
5	440	770
6	550	880

The following graph shows the social cost curve with the negative externality:

1100 T Social Cost Social Cost 770 T Supply Private Cost) O Demand O 330 Private Value) 110 0 QUANTITY (Tons of steel)

The market equilibrium quantity is 5 tons of steel but the socially optimal quantity is 3.5 tons.

The government could impose a tax of $330 per tons of steel.

Explanation: The private cost curve and the private value curve intersect when the quantity is 5 tons. So, market equilibrium quantity is 5 tons. The social cost curve and the private value curve intersect when the quantity is 3.5 tons. So, market equilibrium quantity is 3.5 tons.

The government should impose a tax so that the private costs equals the social cost. The amount of the tax should be equal to the external cost which is $330 per ton.