Consider two firms: a yoga studio and a bar. The bar produces noise which reduces the price that the yoga studio can charge from its customers.
(a) Assume that the bar can sell an unlimited amount of drinks at the market price p and its marginal cost increase in the quantity of drinks. Assume further that the marginal damage to the yoga studio is a constant amount x per drink. Draw the demand curve of the bar, the marginal cost per drink, the marginal external cost, and the marginal social cost. Indicate in the graphic the quantity of drinks in the competitive market equilibrium and the welfare-maximizing quantity of drinks.
(b) Explain why the welfare-maximizing quantity of drinks is welfare-maximizing.