Question

Suppose that the market for flu shots has downward sloping demand and upward sloping supply and that flu shots yield a positive consumption externality of $5 per shot. Show graphically how the private optimum may differ from the social optimum and indicate the deadweight loss. Additionally, show graphically how a subsidy for flu shots can achieve the social optimum.

Answer 1

In the graph, the D=PMB represents the demand curve for flu shots while the S=PMC=SMC is the supply curve. It is to be noted that since the consumption has a positive externality, as the private benefit from consuming it will be different from the social benefit of consumption. So, the D=SMB is the social marginal benefit curve. The private optimum is at the intersection of demand (PMB) and the supply curve, which means the price of P and Q the quantity. however, the socially optimum quantity (at the intersection of SMB and SMC) is Q1 which is greater than the private optimum quantity. The deadweight loss is given by the shaded part in the graph.

If we give the subsidies to the producer, the supply curve will shift to the right due to lower costs, and now the private optimum output will be equal to the socially optimum output of Q1. The lower price has increased the demand for the flu shots which in turn has increased the private benefit to the previous social optimum quantity.