Answer to Question #170222 in Microeconomics for Anna Joseph

Question

1.     A firm emits smoke into the air as a byproduct of its production process.  Assume that the external harm from the smoke is such that the socially optimal amount of production for the firm is zero.  Draw a MD curve that is consistent with this scenario and show why this is a case where the socially optimal amount of output for this firm is zero.    

Answer 1

The socially optimal level of output can only occur in a market with externalites if the marginal private and social curves are equal to each other for both the benefits and the costs.

The diagram above highlights the external cost that is present in a market with a negative production externality. It measures the size of the external cost that can be noticed from parties if the amount of goods produced falls to the socially optimal amount. In the above situation, the marginal external cost exists because there is a divergence between the marginal private cost and the marginal social cost curves.