Question

1 A factory produces carpets and in the process also pollutes into a local river. The demand for carpets is given by: 1)1D 寧200 1:MM) $250 1100 $300 700 The supply of carpets is determined by an industry where each firm has a constant marginal cost of $200 per carpet. The marginal external cost of the pollution, however, is (a) Draw a supply and demand curve diagram using the information given and use it to show the competitive equilibrium price and quantity of carpets. (4 marks) (b) Use the same diagram, or a new one to show that the competitive equilibrium is not efficient. Label the marginal external cost and the marginal social cost. (3 marks) (c) Could taxes or subsidies be used to correct for the inefficiency? Explain what level of tax or subsidy would correct for the inefficiency? (3 marks)

Answer 1

a)

The market for carpets has a marginal cost of $200. Then the supply is perfectly elastic (horizontal) at P=MC=200. The figure below depicts the demand and supply for carpets. The competitive equilibrium quantity demanded at P=200 is 1500. This is private equilibrium.

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b)

Pollution is the byproduct of economic activity that distorts market equilibrium by driving the wedge between the private cost and social cost of an economic activity. The social cost of pollution is private marginal cost plus external cost. In this cost social cost of pollution is $200+$50=$250. At this price the socially desired level of production should be 1200. But as the producers does not take into account the social cost of production, it overproduce the good and the market fails to reach optimum.

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c)

The government can correct the market failure by imposing a tax equal to the cost of pollution or external cost. This will increase the cost of production by the amount of tax and the market will reach the social optimum.