1) In the above question, it is said that for each unit of X produced, an external damage of

$1 is imposed on members of society. Therefore this is an example of negative

externality. Negative externalities arise when an action by an individual or group

produces harmful effects on others’ utility or production function.

In this case, the private MC is equal to the social MC, but the private MB is not equal to social

MB.

Social MB = 9 – X – 1 = 8 – X

Externality
60

50

40
PMB
30 PMC
MB, MC SMB
20

10

0
0 2 4 6 8 10 12
Quantity

We can get the socially efficient level of output by equating SMB with SMC

8–X=3

Or, X* = 5

Under inefficient conditions, the market forces would determine the equilibrium output. Here

PMB = PMC holds

Therefore, 9 – X = 3

Or Xp = 6
The area ABCD shows the dead weight loss due to inefficiencies.

In order to reach the socially optimum level, the government can impose a per unit tax of $1 and

then allow the market to operate freely. This will increase the MC by $1 and MC will shift

upward.
Thus the socially efficient output level is reached and the government collects a tax revenue

equal to $(5×1) = $5. This is shown by the shaded region.

2) The private marginal benefit for commodity X is given by 50-5X, where X is the number

of units consumed. The private marginal cost of producing X is constant at $10. For

each unit of X produced, an external benefit of $5 is imposed on members of society.

Therefore this is an example of positive externality. Positive externality arises when an

action by an individual or a group benefits other individual or groups.

In this case, the private MC is equal to the social MC, but the private MB is not equal to social

MB. Here SMB > PMB.

Social MB = 50 – 5X + 5 = 55 – X

We can get the socially efficient level of output by equating SMB with SMC

55 – 5X = 10

Or, 5X = 45

Or, X* = 9

Under inefficient conditions, the market forces would determine the equilibrium output. Here

PMB = PMC holds

Therefore, 50 – 5X = 10

Or Xp = 8
The area ABCD shows the gain to the society due to the move from the inefficient to the

efficient point.

In order to reach the socially optimum level, the government can provide a per unit subsidy of $5

and then allow the market to operate freely. This will lower the MC by $5 and MC will shift

downward. Thus equilibrium output will increase and reach the socially optimum level.
In this case the expenses of the government increases by $(5×9) = $45. This is shown by the

shaded region.

3) Mary and Sue value a town’s various summer firework presentations differently. Mary’s

demand for the public good is: P = 70 – 10Q. Sue’s demand for the public good is: P =

210 – 50Q. The marginal cost of providing fireworks is $100.

Total demand = PM + PS = P = 70 – 10Q + 210 – 50Q = 280 – 60Q

This is the marginal benefit.

Setting MB = MC, we get,

280 – 60Q = 100

Or, 60Q = 180

Q* = 3

Therefore the socially optimal amount of summer firework presentations is 3 units

If Q* = 3, we will find the marginal benefit of each person.

MBM = 70 – 30 = 40

MBS = 210 – 150 = 60

Therefore, Mary’s burden of tax = 40/100 = 40%

Sue’s burden of tax = 60/100 = 60%

Total tax = $(3×100) = $300

Mary pays = 40% of 300 = $120

Sue pays = 60% of 300 = $180

Mary’s income = $70000

Sue’s income = $30000

Therefore, the share of the tax burden for Mary = 120/70000 = 0.17%

Therefore, the share of the tax burden for Sue = 180/30000 = 0.6%

Since the share of the tax burden for Sue is higher than Mary, Sue is more enthusiastic about

fireworks.