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IAI Actuarial Core Principles · Business Economics · Relationship between the government and the individual firm

A chemical plant in an industrial area releases effluent into a river, harming downstream fishing communities who receive no compensation. Which statement best describes the market outcome in the absence of intervention?

Output is above the socially efficient level. The firm ignores the pollution cost imposed on others, so its private marginal cost is below the social marginal cost, and it produces more than the level where social cost equals social benefit.

  1. AOutput is above the socially efficient level because the firm's private cost is lower than the social costCorrect
  2. BOutput is below the socially efficient level because the firm over-counts its costs
  3. COutput is socially efficient because the firm maximises profit
  4. DOutput is efficient because the fishing communities can freely switch rivers
  5. Output equals the level where social benefit is zero

Explanation

A negative production externality means marginal social cost exceeds marginal private cost. The firm produces where private marginal cost equals price, which is beyond the point where social marginal cost equals marginal benefit. So output is too high. Option 1 reverses the cost relationship.

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