Consider an industry in which there are a large number of potential firms. Each
ID: 1250168 • Letter: C
Question
Consider an industry in which there are a large number of potential firms. Each firm in the industry has the same production process and produces output using capital and labor. Assume that capital and labor both exhibit diminishing marginal returns, so that capital can be substituted for labor in the production process (and vice versa), but capital and labor are not perfect substitutes.
Assume further that each firm is too small to affect the market wage rate for labor and that each firm is too small to affect the market rental rate on capital. Finally, assume that when the firm uses capital, it discharges pollutants into the local river.
Because the town’s drinking water comes from the local river, the townspeople are concerned about water quality and ask the town council to force the firms to discharge less pollution into the local river.
One councilman responds by proposing a tax per unit of pollution that is discharged into the river.
Explanation / Answer
A pollution tax would drive up the cost of a unit of capital, and thus cause a shift in the mix of labor and capital used to favor more labor. This increased demand for labor would increase the relative wage rate.