Consider an industry in which there are a large number of potential firms. Each
ID: 1250304 • Letter: C
Question
Consider an industry in which there are a large number of potential firms. Each firm in theindustry 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.
Now suppose that each firm in the industry is free to choose its optimal level of output.
· How would such a tax affect a firm’s marginal cost curve? Explain.
· How would such a tax affect a firm’s average cost curve? Explain.
· How would such a tax affect the economic profit of firms in the industry? Explain.
Explanation / Answer
This tax makes it more expensive to use the polluting capital, which has the same effect as increase the price of capital. This causes labor to become cheaper, relative to capital -- in other words, the relative wage decreases. Due to the substitution effect, firms switch toward using more labor and less capital. Due to the scale effect (sometimes called the "output effect"), firms cut back on production whenever any input becomes more expensive, and they require less of all inputs (less capital, less labor). The net effect is that firms definitely use less capital, while the chance in labor is ambiguous. (It depends on whether the substitution effect or the scale effect dominates.) Isoquant curves still look the same, but the isocost lines become flatter (assuming that capital is on the vertical axis and labor on the horizontal axis). Each of them pivots on the point where they touch the labor axis. The firm moves to a new, lower isoquant (reflecting the reduction in output).