Analyzing Externalities and Potential for Agreement
A firm produces a good in a competitive market where the price is $90 per unit. The firm's marginal private cost of production is described by the function MPC(Q) = 10 + Q, where Q is the quantity produced. The production process creates a negative externality, imposing a marginal external cost on a third party described by the function MEC(Q) = 0.5Q. The firm is currently producing at its private profit-maximizing output level.
Starting from this profit-maximizing output, explain why a small (infinitesimal) reduction in the firm's output creates the potential for a mutually beneficial agreement. Your explanation should explicitly state the effect of this small reduction on the firm's profit and on the costs borne by the third party.
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