Market failure — practice questions

Market failure: Firms produce where MPC = MPB (private optimum) at Q = 100. They ignore the £6 external cost borne by society.

Social cost: MSC = MPC + MEC = £8 + £6 = £14 at this output — exceeds private cost.

Result: Overproduction — 100 units is above the social optimum where MSC = MSB.

Socially optimal output: Where MSC = MSB, which occurs at a lower Q (e.g. 70 units on a standard diagram). The welfare loss triangle lies between Q* and Q_market.

Policy: Indirect tax of £6 per unit (Pigouvian tax) internalises the externality — shifts supply left to the social optimum (→ 3.2).

1. Calculate the Marginal Social Benefit (MSB): The formula for MSB in the presence of positive externalities is: MSB = Marginal Private Benefit (MPB) + Marginal External Benefit (MEB)

Calculation: MSB = $20 +$15 MSB = **$35**$

2. Explain the Market Failure: At the market equilibrium quantity of 5 million vaccinations, the value to society (MSB = $35) is significantly higher than the value to the individual consumer (MPB = $20). The free market only considers private benefits and costs, so it produces where MPB = MPC (Marginal Private Cost), at a quantity of 5 million.

This is a market failure because the good is under-consumed and under-produced. The socially optimal level of output occurs where MSB = MSC (Marginal Social Cost). Since MSB > MPB at the market price, the quantity consumed (5 million) is less than the socially optimal quantity. This results in a deadweight welfare loss, representing the net benefit society misses out on from the vaccinations that were not consumed.

Policy Implication: To correct this, a government could offer a subsidy of $15 per vaccination to consumers, effectively lowering their private cost and encouraging consumption to move closer to the social optimum.