Open Access and Paper Production

Surrounding the Great Lake are four paper mills, each producing 100 tons of paper per year. The paper is sold on the national market for $2 per ton, and including all the costs of production, costs for each firm are $1 per ton. Thus each firm earns a pure economic profit of $1 per ton. These paper mills require freshwater to operate and also produce a pollutant called gunk, which the mills dump into the Great Lake. New paper mills can also locate on the Great Lake and produce at a base cost of $1 per ton. However, for each new paper mill that arrives, the water will become more polluted with gunk, and each firm will have to install a water treatment facility to obtain freshwater. This externality associated with new plants will raise the costs of paper production at all facilities, including the new one, by $0.15 per ton for each new mill.

a. Assume there is open access to the Great Lake. If paper mills will continue to locate as long as there is any economic profit to be earned, how many new mills will be built? How many mills maximize total combined profits for the paper producers? (Hint: Average revenue remains constant at $2. Create a table that compares average revenues with average and marginal costs as new firms locate around the lake.)

b. Draw a diagram of the marginal cost and marginal revenue curves with the number of mills on the horizontal axis. Assume that government regulation restricts lake access to the profit-maximizing number of firms. Show the resource rent earned by the mills that are allowed to operate.

c. Suppose that government regulation reduced the number of mills by one from the number that would have resulted given open access. Show that the increase in profits to the remaining firms (the resource rent) is sufficient to compensate the firm denied access for its lost profits.