Consider an industry in which there are a large number of potential firms. Each
ID: 1250311 • 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.
Another councilman suggests that – instead of imposing a tax on pollution discharges – the town should
offer firms a subsidy per unit of pollution that they do not discharge into the river.
6. Now suppose that each firm in the industry is free to choose its optimal level of output.
· How would such a subsidy affect a firm’s marginal cost curve? Explain.
· How would such a subsidy affect a firm’s average cost curve? Explain.
· How would such a subsidy affect the economic profit of firms in the industry? Explain.
Explanation / Answer
The subsidy actually causes marginal cost to increase. Producing another unit of output means that the firm would have to use more capital, which reduces their total subsidy. However, average cost goes down, since firms are getting this wad of cash from the government. Firms' profits must go up. Think of it this way: they could still keep their output the same as the pre-subsidy level, but they would get no government subsidy. That pre-subsidy level is still zero profits. But instead, they choose to cut back, in order to take advantage of the subsidy. They wouldn't change to something different if it didn't cause their profits to increase. I hope this is clear. Explaining subsidies can be a bit tricky!