Negative Externalities of Production

The graph above illustrates a negative externality of production of paper. To make paper, paper mills often have to use harsh chemicals like chlorine and sulfur-based products which, if released into the environment, are very harmful to ecosystems. Unfortunately, the production of paper continues to pollute worldwide to this day. These are called external costs of production of paper.

Without any government intervention, the paper mill would only be concerned about their private costs of production (indicated by MPC). Thus, the firm would produce where their MPC curve meets the marginal social benefit (MSB) curve at quantity Q1 and price P1. However, the firm's private costs do not include the social costs of production (MSC) of pollution described above. If the firm were producing where MSC = MSB (Pareto optimality / socially efficient level of output), then they would be producing quantity Q* at price P*. This is not occurring in the free market, and this negative externality of production is indicated by the distance between MPC and MSC (see purple arrow). The red traingles represent the welfare loss to society (where MSC > MSB).


Above, we see one possible solution to the negative externality of production for paper. If the government intervenes to correct this market failure by taxing the polluting paper mill, the firm's marginal private costs increase. This is illustrated by a leftward movement of the MPC curve towards the MSC curve (the magnitude which depends on the amount of the tax; the bigger the tax, the closer to MSC). In this case, the quantity falls to Q2 from Q1 which coincides with a reduction (but not elimination) of the welfare loss to society illustrated by the red traingle.

Other solutions - legislation to punish polluting firms, tradeable emission permits

Evaluation - How much and who should the government tax? What impacts will the tax have on the production process / employment / stakeholders? What are the opportunity costs of these tax revenues? Usefulness of tradeable emission permits?