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Market Failure and Government Intervention
depicted in Figure 15.9 consists of a single firm. The total level of pollution emitted by the firm is measured along the horizontal axis, while the unit cost of pollution is measured along the vertical axis. As before, the MSC curve represents the marginal social cost of production, which includes both the marginal private and marginal externality cost. We know that marginal social cost is an increasing function of the firm’s output level. The marginal social cost curve assumes that the firm is operating with a given level of production technology. Pollution is a by-product of production, and the amount of pollution created is a function of the underlying production technology. We will assume that the level of the pollution created varies directly with the level of the firm’s output (i.e., the greater the level of output, the greater the level of pollution created). On the surface, it may appear that reducing the level of pollution unambiguously benefits society. Unfortunately, nothing could be further from the truth. Pollution is a by-product of production, which generates social benefits. Thus, while reducing pollution lowers marginal social costs, it also results in a reduction of social benefits. This reduction in social benefits may be viewed as the opportunity cost of pollution abatement. This relationship is illustrated in Figure 15.9, where MCA represents the firm’s marginal cost of pollution abatement. The position of the MCA curve depends on the firm’s production technology. If the firm switches to a production technology that results in a lower level of pollution, then the MCA curve will shift upward. The marginal private cost of production will also shift upward because of the use of the new, more costly technology, although the marginal social cost curve may be unaffected because of the reduction in negative, third-party effects. It should be clear from Figure 15.9 that with a given production technology, reductions in pollution can be accomplished only through a reduction in output. Contrary to popular belief, therefore, the optimal level of pollution is not zero, since this would imply a zero level of production. This, of course, begs the question: Is there a socially optimal level of pollution? The optimal level of pollution in Figure 15.9 is r*. To see this, suppose that the firm produced an output level that generated pollution of r¢. At this level, marginal social cost associated with this level of pollution is MSC¢. Reducing production will, of course, reduce the level of production, but at the cost of lower output. As long as the marginal cost of pollution abatement (i.e., the marginal loss of social benefits from production) is less than the marginal cost of pollution, society will be made better off by reducing pollution. On the other hand, if the firm is producing at r≤, then society will be better off by accepting higher levels of production (and pollution), since the marginal cost of pollution abatement is greater than the marginal social cost of pollution. Clearly, society’s welfare will be maximized where the marginal social cost of pollution is equal to the marginal cost of pollution abatement, which in Figure 15.9 occurs at pollution level r*. Of course,
