A firm that produces pulp also emits smelly pollution. The more pulp it produces, the more pollution it emits. The pollution primarily affects the people who live in the area.
Suppose the pulp is sold in a perfectly competitive market and that the firm has linear marginal cost, MC, which increases with production.
Suppose also that the marginal cost of pollution, ME (the marginal cost of the externality), increases proportionally to the quantity produced, and is approximately 1/3 as large as the firm's marginal cost.
a) Draw a diagram with quantity of pulp on the X-axis and cost/revenue on the Y-axis. Indicate the profit maximizing choice of quantity given the assumptions.
b) How should the social cost be represented in the graph? Draw it.
c) Show in the graph how to find the socially optimal quantity. Will that quantity be higher or lower than in the answer to a)?
d) Suggest a solution how to motivate the firm to produce the socially optimal quantity.