Consider an industry in which there are a large number of potential firms. Each firm in the industry has the same production process and produces output using capital and labor. Assume that capital and labor both exhibit diminishing marginal returns, so that capital can be substituted for labor in the production process (and vice versa), but capital and labor are not perfect substitutes.
Assume further that each firm is too small to affect the market wage rate for labor and that each firm is too small to affect the market rental rate on capital. Finally, assume that when the firm uses capital, it discharges pollutants into the local river.
Because the town's drinking water comes from the local river, the townspeople are concerned about water quality and ask the town council to force the firms to discharge less pollution into the local river. One councilman responds by proposing a tax per unit of pollution that is discharged into the river.

1. Suppose that each firm in the industry minimizes the cost of producing a given level of output.
·  How would such a tax affect the relative wage rate? Explain.
·  How would such a tax affect the optimal combination of capital and labor that each firm uses to produce output? Explain.
·  Illustrate your answer to the previous question with isoquants and isocosts.

2. Now suppose that each firm in the industry is free to choose its optimal level of output.
·  How would such a tax affect a firm's marginal cost curve? Explain.
·  How would such a tax affect a firm's average cost curve? Explain.
·  How would such a tax affect the economic profit of firms in the industry? Explain.

3. If firms can freely enter and exit the industry, then:
·  How would such a tax affect the market supply curve in the industry? Explain.
·  How would such a tax affect the market equilibrium price of output? Explain.

4.  Explain how such a tax would reduce the amount of pollution discharged into the river.