Question

3. Assume that a mining company that produces ore sells its product for $40 per ton. Also assume that the $40/ton price represents both the private and social benefit per ton. In producing ore, the mining company incurs costs, represented by MPC. Furthermore, the pollution the company generates travels down stream to impose additional “external” costs on society, represented by MEC. Both the private costs to the firm and external costs are as follows.

Ore Mined (tons) MPC to firm ($/ton) MEC ($/ton)

1 $7 $5

2 $15 $11

3 $24 $16

4 $40 $26

5 $45 $35

a. If the firm only considers its private benefits and costs, what level of production will occur?

b. From a social perspective, what’s the socially efficient level of production?

c. Are your answers for parts a and b different? If so, explain why?

d. What kind of policy would ensure a social efficient outcome in this case?

Answer 1

(a)

In private equilibrium, Price = MPC

This holds true when Q = 4, when P = MPC = $40.

(b)

In socially efficient outcome, Price = MPC + MEC

This holds true when Q = 3, when P = MPC + MEC = $24 + $15 = $40.

(c)

Private market outcome results in higher quantity, leading to overproduction. This is because private outcome ignores the externality cost.

(d)

When Q = 3, MEC = $16.

So, to ensure efficient outcome, government should impose a Pigouvian tax of $16 per unit.