Question

When a person gets an influenza vaccine, he or she is less likely to get sick with the flu. This makes it less likely for that person to pass the flu to someone else. Suppose that the external benefit created by the influenza vaccination is equal to $100 per dose.

(a) In a diagram, show the equilibrium in the influenza vaccine market. Also, show the quantity that would maximise social surplus. Is this equal to the perfectly competitive market equilibrium quantity? Fully explain your answer.

(b) Thanos suggests an alternative policy. He says that if the government puts a $100 per dose tax on the vaccine then this will maximise social surplus. Is he correct? If he is correct, show the social gain under his policy compared to the perfectly competitive equilibrium. If he is incorrect, show the deadweight loss under her policy. Note: Illustrate your answers using the diagram drawn for part (a).

Answer 1

In this case, the dose of influenza vaccines is an example of a positive externality as getting the vaccine will make less likely for the person to pass on this virus to somebody else. So, there is no adverse impact on the third party. Rather there is a benefit to the non-market participants.

Let the external benecit created be equal to $100/dose

Take a look at fig 1 for the equilibrium influenza vaccine market: MSC = Marginal social cost,

MPC = marginal private cost, MPB = marginal private benefit, MSB = marginal social benefit

First, let us suppose we know nothing about this externality, so market equilibrium will take place at the intersection of the supply and demand curves i.e. MPC and MPB curves. Notice that here, MPC = MSC as there is no external cost/benefit. This occurs at Q₁. This is the perfectly competitive equilibrium quantity. The market surplus at Q₁ is computed by deducting total private costs from total private benefits = (b+c) - (c) = b.

The social surplus at this equilibrium quantity is computed by deducting total social costs from total social benefits = (a+b+c) - (c) = (a+b)

Now, you can see in the graph, the MSB curve lies above the MPB curve for all the quantities because for each unit of private consumption , there is a spill-over benefit to the non-market/third party participants. This area between the MSB and MPB curve equals to the external benefit.

So, MPB + MEB = MSB.

So, if now we increase the quantity more than the equilibrium quantity, i.e. Q_2, the market surplus will be : (b+c+g) - (c+f+g) =(b-f)

The social surplus at this quantity will be equal to (a+b+c+d+f+g) - (c+f+g) = (a+b+d)

So, we see at this quantity the social surplus is maximum , inspite of the fact that the participants of the market are made worse off. So, there has been a potential pareto improvement in this case. So, (d+f) is is the gain of the non-market participants due to the increase in production from Q₁ to Q₂.

And 'f' is the loss to the participants in the market due to excess production. Also, 'd' is teh deadweightloss of the economy in the presence of a positive externality,

So, we see that the perfectly competitive quantity does not yield maximum social surplus as markets tend to under-produce as producers do not consider these additional benefits to others.

b) Now, if the parties or the suppliers who are creating this external benefits for others, i,e. people who are giving the vaccine, if they are compensated for these external benefits, then they would have an incentive to increase their production. This could result in the quantity being equal to the one that maximizes social surplus.

However, in this case, if the govt. puts a $100 tax per dose, the producers will further reduce their supplies as it is increasing their costs of production and reducing their profits. So, this will further reduce the social surplus. So, he is not correct. The tax will will shift the MPC curve upwards by its amount and the producers have an incentive to reduce the output to Q₃. The shaded area shows the tax revenue. This will further increase the deadweight loss. Take a look at fig 2: The deadweight loss under this policy is: (d' + f') which is due to the taxation and the reduction of the quantity below the equilibrium level.

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