Somewhere in Pennsylvania, a natural gas company is extracting natural gas from a well using hydraulic fracturing. This technology requires the use of large amounts of water, which they pump out of a nearby river. Downstream from the natural gas well, a farmer also uses water from the river to irrigate his crops. Since the natural gas company has started pumping water out of the river, there isn’t enough flow left in the river to fully irrigate the farmer’s crops. As a result, the farmer is losing large portions of his crops.

a. Using a simple supply and demand diagram, model this negative externality associated with natural gas production. Be sure to show both the competitive and socially optimal equilibrium prices and output of natural gas. Show the increase in economic welfare that would result from moving from the competitive to the socially optimal equilibrium.

b. How might the Pennsylvania state government construct a policy that would induce the natural gas companies to produce the socially optimal amount of natural gas?