Question

2. Consider a downward-sloping market demand and an upward-sloping marginal cost. For each of the following situations, show the Social Marginal Benefit and Social Marginal Cost curves and explain whether the presence of the externality leads to a monopoly equilibrium with too much or too little production relative to the socially optimal outcome. (a) A negative externality associated with production (b) A negative externality associated with consumption (c) A positive externality associated with consumption.

Answer 1

(a) Due to negative externality in production, there is an external cost associated with production due to which social marginal cost (MSC) is greater than the marginal cost (MC) of production as MSC = MC + external cost. There is no effect on assumption so that demand curve (D) is also the social marginal benefit (SMB) curve. Socially optimal outcome is Q* determined at the intersection of MSC and SMB whereas monopoly outcome is Q' determined at the intersection of D = SMD and MC As Q' is greater than Q* so extensity leads to monopoly equilibrium with 100 much production relative to socially optimal outcome. (b) Due to negative externality in consumption there is negative effects on consumers due to which the social marginal benefit (SMB) is less than the demand (D) or private marginal benefit (IMB) As SMB = D or PMB + external effects (negative) there is no effect on production.
This answer talks about the impact of different types of externalities in production and consumption on socially optimal and monopoly outcome.