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Market Failure Due to Externalities 459

As with most activities, the marginal cost rises with increasing levels of cleanup.

(The cheapest forms of cleanup are undertaken first.) The marginal benefit of

cleanup falls as health gains from cleanup (although positive) exhibit diminish-

ing returns. The optimal amount of cleanup occurs at Q*, where MB MC, well

short of complete elimination. Beyond this level, the extra benefits are not worth

the costs.^8

The government can promote an output Q* through either pollution fees

or quantity standards. The appropriate fee is set at the value of marginal ben-

efit of pollution reduction. Alternatively, the regulator could attain the same

result by mandating Q* as the minimum abatement standard. When the regu-

lator has perfect knowledge of the marginal benefit and cost schedules, either

regulatory regime can be used to attain the desired result.

Marginal Benefits and Costs

Marginal benefit of cleanup

Marginal

cost of

cleanup

Optimal

pollution fee

T = MB* = MC*

0%

cleanup

Q* 100%

cleanup

Quantity of Pollution Cleaned Up

Optimal

cleanup

Q*

Q

FIGURE 11.2

Optimal Regulation

of an Externality

The optimal amount

of cleanup is

determined at Q*,

where the marginal

benefit of cleanup

matches the marginal

cost.

(^8) This economic point may seem patently obvious. Nonetheless, it is at odds with the Environmental
Protection Agency’s legislative mandate to promote and improve the quality of the environment
without regard for cost.
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