Question

Kunra is located in Boston and produces cars. In the course of car production, Kunra releases pollution as a negative externality into the atmosphere of Boston. Some of the pollution-related problems include skin cancer, contamination of drinking water, breathing epidemics, birth defects, and offensive odor. Sadly, Kunra does not do anything to bear the costs associated with the health and ecological problems Boston residents suffer. Interestingly, Kunra believes that Boston residents do not know about the problems and then leaves Boston residents to pay for the health and ecological problems they suffer from the pollution generated in the production of cars. What a rip-off against Boston residents!!! Kunra smiles home with huge profits. Kunra’s customers outside Boston feel satisfied with Kunra’s cars and organize events to praise the incredible quality of Kunra’s cars. Alas, Boston residents apparently turn out to be victims in the process of production and consumption of Kunra’s cars.

Suppose that you are a public administrator in Boston’s City Government, have trained in Economics for Public Administrators from Clark Atlanta University, and are working with the following marginal benefits and costs for Kunra’s car production, where Q is thousands of cars and P is price per car:

MPB (Marginal Private Benefit) = 120- 0.6Q (benefits to individual consumers of Kunra’s cars).

MPC (Marginal Private Cost) = 20 + 0.4Q (costs of producing cars by Kunra).

MEB (Marginal External Benefit) = 0 (an external benefit is a positive externality: car production benefits to Boston may include a healthy environment and healthy residents in Boston. In the current context, external benefits are zero).

MEC (Marginal External Cost) = 0.25Q (an external cost is a negative externality: health and ecological problems associated with the pollution generated by Kunra that affect Boston’s residents and environment).

Find the competitive equilibrium, Qc and Pc; the efficient equilibrium, Qe and Pe; and show the competitive equilibrium and the efficient equilibrium in the same graph that is properly labeled.

Answer 1

Here, the situation is as under:

MPB (Marginal Private Benefit) = 120 - 0.6Q
MPC (Marginal Private Cost) = 20 + 0.4Q
MEB (Marginal External Benefit) = 0
MEC (Marginal External Cost) = 0.25Q

The demand curve is: MPB (Marginal Private Benefit) = 120 - 0.6Q

Since MEB = 0, this is also the marginal social benefit curve.

There are two supply curves:

MPC (Marginal Private Cost) = 20 + 0.4Q     -- the private supply curve

We know that MPC + MEC = MSC               --   the social supply curve

Thus, MSC = 20 + 0.4Q + 0.25Q

MSC = 20 + 0.65Q (this causes the private supply curve to shift leftwards)

It can be seen here that the socially desirable supply is less than the private supply.

The competitive equilibrium is the private equilibrium, between private demand and private supply. Thus equating the two:

120 - 0.6Q = 20 + 0.4Q

Thus, Q = 100 (or 100,000 cars, since Q is in thousands)

Substituting the value of Q in the demand equation

120 - 0.6(100) = P

Thus, P = 60 (or $60,000 per car)

Thus, the private equilibrium is at Q = 100,000 cars, and P = $60,000 per car

Now, the efficient equilibrium is the socially optimal equilibrium

Thus equating private demand with social supply:

120 - 0.6Q = 20 + 0.65Q

100 = 1.25Q

Q = 80 (or 80,000 cars)

Substituting this value in the demand equation

P = 120 - (0.6)80

P = 120 - 48

P = 72 (or $72,000 per car)

Thus, the social equilibrium is at Q = 80,000 cars, and P = $72,000 per car

This entire situation can be seen graphically: