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.

(C) Indicate at least two possible remedies (relying on course concepts) for the problems of contamination in (A) and (B).

Answer 1

As it can be seen in the above graph,

PMB is the private marginal benefit curve of individual which is the demand curve and also the social marginal benefit curve of SMB

PMC is the private marginal cost curve

SMC is the social marginal cost curve. The SMC is to the left of the PMC because of the presence of negative externality.

Optimal production point is Q2 while free market production point is Q1. This means actual production is more than socially optimal production and thus needs to be reduced.

c)

The two possible remedies are: Imposing a tax on upstream users equal to the external cost imposed which equals P2-P1

Or, bargaining among the upstream and downstream users to reach a production point of Q2