Consider an industry in which there are a large number of potential firms. Each
ID: 1250312 • 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.
8. Which policy – the tax or the subsidy – would cause less pollution to be discharged into the river? Explain.
Explanation / Answer
A tax will reduce pollution more. Both policies have exactly the same effect on firms: they cause firms to use less polluting capital, and firms produce less output. However, the tax reduces firms' profits. In the long run, this will cause some firms to leave the industry, and pollution goes down further. The subsidy increases profits, which encourages new firms to enter the polluting industry. This causes output, capital use, and pollution to increase. In fact, a "subsidy for reducing pollution" could cause pollution to increase in the long-run. Since you're subsidizing a polluting industry, you're encouraging more people to enter the polluting industry.