Question

Questions 5, 6, and 7 consider the perfectly competitive market for Honey. Honey is produced by beekeepers, each of which have traditional U-shaped average cost curves. There are many firms in the honey industry, each producing a homogeneous product: honey. Market demand for honey can be characterized as a downward sloping linear function.

Question 5: For this question, ignore any externalities that might be associated with the production of honey. Graphically indicate the demand (D0) and Supply (S0) and the equilibrium in the market for honey. Show the equilibrium price and quantity, Q0 and P0. Indicate on your graph the areas of consumer surplus and producer surplus. What is the output level the Benevolent Dictator would like to see in this market? Why?

Question 6:

Now suppose that scientists have discovered that the production of honey has a very significant positive externality. The main input into honey production, honey bees, are most effective when there are orchards nearby. The bees gather nectar from the orchards and simultaneously pollinate the orchard. This pollination is very valuable to the orchard.

However, honey firms (beekeepers) are not compensated for this positive impact on orchards. This positive externality means that the true marginal social value of producing honey is different than the marginal private value of the consumption of honey. Indeed, the Marginal Social Value for the industry would be the sum of the marginal private value (the demand curve) plus the positive impact each unit of honey production has on orchards. That is, in the eyes of the benevolent dictator, the production of honey has Marginal Social Value per unit higher than the marginal private value (the demand curve).

• Construct another graph. Show the original demand and supply (labeled correctly as D₀and S₀) and equilibrium price (P₀) and quantity (Q₀).
• Now add another curve that reflects the Marginal Social Value given the existence of the positive externality, and label it appropriately.
• What, if anything, happens to price and quantity of honey established in the marketplace, given the presence of this positive externality?
• What is the output Q_SO6the Benevolent Dictator would choose (where SO6 stands for Socially Optimal output here in question 6, which may or may not be different than the socially optimal output you found in question 5)?
• Indicate graphically and explain in a narrative the area of deadweight loss (DWL), if any, given the existence of this positive externality. What does deadweight loss mean in this context?

Answer 1

5. The graph with original equilibrium is:

Here, D0 is the demand for honey and S0 is the supply of honey. Output is at Q0 and price at P0.

Consumer surplus is the area of the triangle labelled CS which is above P0 and below D0.

Producer surplus is the area of the triangle labelled PS which is below P0 and above S0.

The benevolent dictator would like to see Q0 according to this graph because demand and supply are in equilibrium. There is no wastage of welfare as it is shared by sellers and buyers (no deadweight loss)

2. In this graph, D0 is the original demand curve and S0 is the original supply curve. Q0 is the original equilibrium quantity and P0 is the original equilibrium price.

  

When honey bees give out positive externalities, MSB (marginal social benefit) is the new curve. Now the benevolent dictator would desire output at Q1 which is greater than Q0. P1 greater than P0 will be the new price.

The orange triangle at the center, between Q0 and Q1 above P0 is the deadweight loss.

DWL indicates the opportunity cost to the society. It is the difference between what is produced and what should have been produced.This is because, at Q0, marginal social benefit (benefit received by the society) is greater than individual private cost (the demand curve of the individual making the decision). So, less is produced than is socially optimum. Consumers pay P0 and consume Q0. As seen in the graph, this is below the socially optimum quantity of Q1 at price P1. That is why the situation results in dedweight loss, indicating loss of economic welfare.