Question

Suppose a city has its water supply contaminated. In other words, suppose upstream users (upper half of a watershed) damage the water quality for downstream users (lower half of the watershed).

(A) Describe, using economic terms, the loss of well being to the cities municipal customers.

(B) Define the types of costs that may be inflicted on the city’s water treatment plant and illustrate with a graph.

Answer 1

A) Let me first define the concept of externality. Externality is defined as the additional cost or benefit associated with any economic activity. If the economic activity has an additional good impact then it is classified as Positive Externaity. If the economic activity has an additional adverse impact then it is classified as Negative Externality.

Here , in the question since upstream users are using the water supply and in the process damaging the water quality for downstream users the use of water supply by upstream users has an adverse impact on downstream users. Hence, the use of water supply by upstream users results in negative externality in demand side. Thus, there is a welfare loss to the municipal customers as the consumption of water supply by upstream users is more than what is efficient for economy.

B) If a tax is imposed on consumption of water supply by upstream users, the private marginal cost curve will shift upward. This will result in equilibrium quantity falling and becoming equal to socially efficient quantity. This tax is known as Pigouvian Tax.