Paper mills create unpleasant odors that negatively affect people who live and work in the vicinity of the mills. Assume paper mills operate in a perfectly-competitive market.
1. Draw a correctly labeled graph to represent the market for paper and include the following:
i. The marginal private costs and marginal private benefits of paper labeled MPCMPC and MPBMPB, respectively.
ii. Label the market price PMPM and the market quantity QMQM.
iii. Label the socially optimal quantity QSQS.
iv. Shade the area on the graph that represents the area of deadweight loss.
2. Now assume the government grants a per-unit subsidy for the production of paper. Will the subsidy increase, decrease or have no effect on the deadweight loss in this market? Explain.
Answer (1)
Graph ExplanationSince I can't draw directly in this reply, I’ll describe what your graph should look like:Axes:Y-axis: Price (P)X-axis: Quantity (Q)Curves:Demand Curve (MPB): Downward sloping – represents Marginal Private Benefit = Marginal Social Benefit (since consumption doesn't have an externality).Supply Curve (MPC): Upward sloping – represents Marginal Private Cost.MSC Curve (Marginal Social Cost): Lies above the MPC curve – reflects the negative externality (unpleasant odor from paper mills).Points to Label:PM and QM: Intersection of MPB and MPC – this is the market equilibrium (where only private costs/benefits are considered).QS: Intersection of MPB and MSC – this is the socially optimal quantity (where full social costs are considered).Deadweight Loss (DWL): Shade the triangle between MSC and MPC, from QS to QM.This area represents the overproduction of paper that leads to a social cost not accounted for by producers.Effect of a Per-Unit SubsidyA per-unit subsidy lowers the MPC, shifting it downward (to the right).Since this is a negative externality, the subsidy would:Encourage more production.Increase quantity further beyond the socially optimal level QS.Worsen the overproduction problem.Conclusions:The subsidy will increase the deadweight loss.It moves the market further away from the socially optimal outcome, increasing the gap between QM and QS.
