from MIC, the pretax curve), and the competitive market equilibrium
becomes P* $5 and Q* 8 million liters, precisely the efficient outcome.^7458 Chapter 11 Regulation, Public Goods, and Benefit-Cost Analysis(^7) Note that the full cost increase due to the externality is passed on in the form of a higher price
to purchasers of the chemical. This should not be viewed as somehow unfair. Rather, before the
pollution tax, consumers were enjoying an unduly low price, one that did not reflect the full social
cost of producing the chemical. Internalizing the externality means that the competitive price will
now (fairly) reflect all relevant production costs.
CHECK
STATION 2
Suppose the $1 pollution tax is instituted. Among the affected groups—chemical con-
sumers and suppliers, the government, and the general citizenry—who gains and who
loses from the program, and by how much? What is the net gain to society as a whole?
Now suppose the firm has available the technology to chemically treat and
eliminate harmful pollutants. For concreteness, take the cleanup cost to be
$.50 per unit of pollution. Note first that absent any pollution fee or tax, there
is absolutely no incentive for the firm to engage in cleanup. Cleanup simply
means incurring additional costs. However, suppose the $1 tax per unit of pol-
lution is in place. Now the firm’s cleanup incentive is obvious. It is cheaper to
eliminate the pollution (a $.50 per unit cost) than to pollute and pay the gov-
ernment tax. Thus, the firm’s cost-minimizing strategy is 100 percent cleanup.
How does this affect price and output in the chemical market? In Figure 11.1,
the (external) cost of pollution is replaced by the (internal) cost of cleanup.
The market price becomes $4.50 (reflecting the full cost of production and
treatment), and total production increases from 8 million to 9 million liters.
With a $1 tax and a treatment cost of $.50, complete cleanup is both pri-
vately and socially efficient. From a societal viewpoint, it is less costly for the
firm to expend resources for cleanup than for society to suffer the external
costs of pollution. Instead, what if the cost of cleanup is $1.50 per unit? Facing
a $1-per-unit pollution fee, the typical firm finds it cheaper to pay the tax than
to clean up, so no pollution treatment occurs. It is important to recognize that
this result is also efficient! Since the cost of cleanup exceeds the resulting ben-
efit, it simply is not worth eliminating the pollution.
Remedying Externalities
The adverse effects of externalities can be ameliorated by a number of means,
including (1) government taxes, standards, or permits, or (2) monetary pay-
ments between the affected parties established via bargaining or by the courts.
We will take up each of these approaches in turn.
We already introduced the argument for imposing taxes and fees on the eco-
nomic agent causing the externality. Let’s take a closer look at the benefits and
costs of reducing the externality. Figure 11.2 reconsiders pollution cleanup in its
own right, separately from its implications for the output of the chemical industry.c11RegulationPublicGoodsandBenefitCostAnalysis.qxd 9/29/11 1:34 PM Page 458