A firm that produces steel is polluting the air. Assume that the marginal cost of producing steel is constant at £4. The inverse market demand for steel is P = 44 – 2Q, where P is the price of steel and Q is the 1 quantity of steel. The air pollution associated with steel production is creating an externality given by £2 Q.

Assuming that the market for steel is competitive, what is the profit-maximizing level of steel when only marginal private costs are taken into account? The marginal social costs are given by the sum of the marginal private costs plus the externality. What is the social level of steel output? Show your solution graphically. What is the social loss associated with the externality? How can we solve this externality problem using taxation?