Question

Question 1; Greater consumption of alcohol leads to more motor vehicle accidents and, thus, imposes costs on people who do not drink and drive.

a) Illustrate the market for alcohol, labelling the demand curve, the supply curve, the social marginal benefit curve and the social marginal cost curve. Label also the market equilibrium quantity and the allocative efficient quantity of output.

b) On your graph, shade the area corresponding to the deadweight loss of the market equilibrium.

Explain. (Hint: The deadweight loss occurs because some units of alcohol are consumed for which the social marginal cost exceeds the social marginal benefit).

Question 2 Consider the market for fire extinguishers.

a) Why might fire extinguishers exhibit positive externalities?

b) Draw a graph of the market for fire extinguishers, labelling the demand curve, social marginal value curve, the supply curve, and the social marginal cost curve.

c) Indicate the market equilibrium level of output and the socially-efficient level of output. Give an intuitive explanation for why these quantities differ.

d) Given the information that the external benefit is $10 per extinguisher, describe a government policy that would yield the efficient outcome.

Answer 1

a. The diagram above shows the case of negative externality where market efficient equilibrium occurs at the point where PMC = MB and the socially efficient equilibrium occurs at the point where SMC =MB. The market efficient quantity is above the socially efficient quantity.

b. The red shaded area represents the deadweight loss due to negative externality of the product. Because a private firm does not take into consideration the social cost associated with the good in case of negative externality.