I. Producing steel involves internal costs, such as the time and effort of the steelworkers, and external costs, such as pollution.
A. Briefly explain why it is only the external costs that pose a problem for getting an efficient outcome.
Because the factory takes account of internal costs in deciding how much to produce and how to produce it, hence, in order to maximize its profit, produces in that way which maximizes net benefit--counting internal costs and benefits, but not external ones.
B. Briefly sketch the three alternative approaches to solving that problem that we have considered.
The three are regulation, Pigouvian taxes (aka effluent fees) and Coaseian bargaining. I have already sketched them in my words.
C. For each of the three alternatives, describe a situation where it doesn't work and briefly explain why.
Regulation: Does not work for pollution in situations where the cost of controlling pollution varies widely from firm to firm, and is not readily discovered by the regulators--since they cannot tell what control measures are efficient for each firm, and so cannot tell the firm what to do.
Effluent fees: Does not work when the external cost is hard to measure. Does not work when the court (or equivalent) does not know which party can control the problem at lower cost.
Coaseian bargaining: Does not work for controlling pollution in southern California--because the number of parties is so large as to make bargaining costs prohibitive.