A necessary condition for the efficient allocation of resources is the absence of
externalities. Construct a simple economy with two firms, say, 1 and 2. Firm 1 produces
an output x,
which is sold in a competitive market but imposes an external cost, say, e(x)
to firm 2. The external cost is assumed to be convex and strictly increasing. Firm 2
produces an output y,which is also sold in a competitive market but does not impose an
externality cost to firm 1. Each of the two firms has a cost function that reflects the
private cost of producing the output.
(a) How does the socially optimum output level compare with that of profit-maximizing
level of output under competitive market conditions when firm 1 takes account only of
the private cost of production and ignores the social cost (the external cost)?
(b) Comment on the socially optimum output vis. s vis. the competitive output level
when the two firms merge to internalize the externality.