Toxic waste dumped into a river

Dumping waste for free means each firm ignores a cost its production puts on others, such as the people downstream. The industry's supply curve reflects only private cost, which is lower than the true social cost. As a result the market produces too much at too low a price.

A policy that fixes this, such as a per-unit tax equal to the harm or a rule making firms pay to clean up, puts the external cost back into the firms' own costs. The industry supply curve shifts left toward marginal social cost. Along the same demand curve, a leftward supply shift means a smaller quantity and a higher price.

So output decreases and price increases, moving the market toward the efficient quantity.

Each choice

• A. Output and price falling together is what a drop in demand does. The policy changes firms' costs, which shifts supply, and a supply decrease raises price.
• B (correct). Making firms pay for the waste shifts supply left, which cuts output and raises price.
• C. This is a rightward shift in supply, as a subsidy would cause. Correcting an external cost does the opposite, since the market was already producing too much.
• D. Output and price rising together is a demand increase. Nothing about cleaning up a river makes buyers want more of the product.
• E. An industry with an external cost already overproduces. Efficiency calls for less output, not more.