Question

Let's look at the case of a small island nation with a single plant producing electricity Assume for the purpose of question 2 that the MC is upward sloping. a. First assume there are no externalities of any kind 2. i. Draw the demand, marginal revenue and (private and social) marginal cost curves of this monopoly ii In the graph drawn label the (1) profit maximizing quantity and (2) socially efficient quantity Now suppose the production of electricity causes a large emission of pollution which negatively affects the residents of the island nation: medical bills from respiratory problems and lost wages due to poor health. Repeat part ai-aii on a separate graph. b c. Looking through your answers to parts a and b explain whether the following sentence is true or false: A monopoly can never produce the socially efficient quantity.

Answer 1

(a)

In following graph, profit is maximized at point A where MR and PMC intersect with price P0 and output Q0.

P.MR, MC JMC PMC A D MR

(b)

Pollution creates an external cost which increases PMC by amount of external cost, to social marginal cost (SMC), where SMC lies to the left of PMC. Social optimal outcome is at point B where MR intersects SMC with higher price P1 and lower output Q1.

(c)

In absence of externality, socially optimal quantity is produced at point C where Demand (D) intersects MC with socially optimal price P2 and output Q2. Since both Q0 and Q1 are less than Q2, it is evident that monopoly cannot produce socially optimal quantity, even if the monopolist internalizes the externality.