Consider an industry in which there are a large number of potential firms. Each
ID: 1250308 • 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.
4. Explain how such a tax would reduce the amount of pollution discharged into the river.
Explanation / Answer
Since the tax causes firms to produce less output, they use less of the polluting capital. On top of that, for the output that they produce, they switch to a combination of inputs that favor more labor and less capital. Both of these effects cause their capital use to go down, so their pollution also goes down.