Question

Assume that a firm produces organic waste that has the effect of increasing the fertility of neighbouring farmland and thus reducing the farmers’ costs. It is impractical, however, to sell the waste to the farmers. The following table shows the firm’s private marginal costs and these external benefits to farmers from the firm’s production.

Output (units)	Price (£)	Marginal (private) costs (£)	Marginal external benefit (£)	Marginal social cost (£)
1 2 3 4 5 6 7 8 9 10	20 20 20 20 20 20 20 20 20 20	16 15 15 16 17 18 20 22 24 27	6 5 4 3 2 2 2 2 2 1	…… …… …… …… …… …… …… …… ……

Explain which type of externality appears in this case.

Assuming no government intervention, how much will the firm produce to maximise profits?

Fill in the column for marginal social cost? What is the socially optimum level of output?

In graph paper (or using excel), use the data from the table to draw a diagram representing this externality. Calculate the wellfare lost without government intervention.

What subsidy per unit would the government have to pay the firm to encourage it to produce this level of output? What would it cost the government?

If new farming technology doubled the benefit of the waste to the farmers, what will now be the socially optimum level of the firm’s output?

Answer 1

• This is a case of Positive externality. A positive externality is a benefit that is enjoyed by a third-party as a result of an economic transaction. Third-parties include any individual, organisation, property owner, or resource that is indirectly affected. Here the farmers gain the organic waste from the fimr's production.
• The firm produce 7 units to maximise profits
• The socially optimum level of output 8 units (where P = MSC)
• Subsidy per unit would the government have to pay the firm to encourage it to produce this level of output is £2 (= marginal external benefit). The government would cost : £2*8 = £16
• If new farming technology doubled the benefit of the waste to the farmers, the socially optimum level of the firm’s output 9 units (where P = MSC = £20)