Suppose that the demand for a product is Q = 100 - 4P and supply is Q = -20 + 2P where P is price. The external damage or cost (EC) caused by the good is $8 per unit. Plot a graph showing the demand curve, the supply curve, the marginal social cost curve, the perfect competition equilibrium, and the efficient production level. Shade in the triangle is associated with societal surplus. Outline with a dark line any surplus lost due to production at the inefficient market equilibrium.

 

Next, use the equations to calculate the equilibrium level of production in a perfectly competitive market, the efficient level of production, and the lost surplus due to the externality. Hint - Solve for equilibrium with Qs = Qd, solving for price, and substituting price back into supply or demand. The efficiency condition is MB = MSB = MSC = MC + EC. Private marginal costs and benefits can be found by solving supply and demand curves for price and then replacing P in the equation with either MC or MB. Then set up the equation for MSB=MSC. Efficiency losses are measured as areas and the area of a triangle is 1/2 times the base times the width. The picture is likely to help you see how to calculate the deadweight loss.

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To start lets solve for the equilibrium price and quantity in a perfectly competitive market by sett... View the full answer