17.2 The Inefficiency of Competition with Externalities
Competitive firms and consumers do not have to pay for the harms of their negative externalities, so they create excessive amounts. Similarly, because producers are not compensated for the benefits of a positive externality, too little of these externalities is produced.
To illustrate why externalities lead to nonoptimal production, we examine a competitive market in which paper mills produce paper and by-products of the production process—such as air and water pollution—that harm people who live nearby. We’ll call the pollution gunk. Each ton of paper produced increases the amount of gunk by one unit. The only way to decrease the volume of gunk is to reduce the amount of paper manufactured. ...
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