East Chicago is a major production center of steel in the United States. In the

Question

East Chicago is a major production center of steel in the United States. In the process of producing steel, the firms in this are emit pollution both into the air and into the water which adversely affect Indiana residents. The EPA has determined that that the external marginal cost of this pollution to Indiana residents is MCexternal = 10Q. The Chicago-area steel mills' marginal (private) cost of producing steel is 20Q. The inverse market demand for steel has been estimated to be P = 180 - 2Q. ("Q" refers to steel output in thousand-tons). a) Given this information, how many tons of steel do the residents of Indiana prefer Chicago-area steel mills to produce? Illustrate graphically. b) Assuming this is a perfectly competitive industry, how many tons of steel will these mills produce in the course of maximizing profits? Illustrate graphically (on the same graph as a) c) Why do your answers for parts a and b differ? In your answer, be sure to discuss the nature of "market failure" here (why does it occur), and suggest a way that it may be eliminated.

Explanation / Answer

Produce where marginal cost (MC)= marginal revenue (MR) Revenue= PQ = 180Q- 2Q^2 MR (derivative)= 180- 4Q a) Social cost is 20Q+10Q=30Q MC= 30 30= 180-4Q Q= 150/4 = 37.5 b) Private cost is 20Q MC=20 180-4Q= 20 Q= 40 C) Differ because the mill is not taking the social cost into account when analyzing production quantities. It could be eliminated by forcing the steel mill to internalize the social costs of production/pollution, either by taxation or forcing it to purchase pollution credits.

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