Question

Surrounding the Great Lake are four paper-mills, each producing 100 tons of paper per year. The paper is sold on the national market for $2 per ton, and including all the costs of production, costs for each firm are $1 per ton. Thus each firm earns a pure economic profit of $1 per ton. These paper mills require fresh water to operate, and also produce a pollutant called gunk, which they dump into the Great Lake.

New paper mills can also locate on the Great Lake, and produce at a base cost of $1 per ton. However, for each new paper mill which arrives, the water will become more polluted with gunk, and each firm will have to install a water treatment facility to obtain fresh water. This externality associated with new plants will raise the costs of paper production at all facilities, including the new one, by $.15 per ton for each new mill.

1. Assume there is free access to the Great Lake. If paper mills will continue to locate as long as there is any economic profit to be earned, how many new mills will be built? What is the number of mills that maximizes total combined profits for the paper producers? (Hint: Average revenue remains constant at $2. Create a table which compares average revenues with average and marginal costs as new firms locate around the lake.)

2. Suppose that government regulation reduced the number of mills by one from the number that would have resulted given free access. Show that the increase in profits to the remaining firms (the resource rent) is sufficient to compensate the firm that is denied access for its lost profits.

Answer 1