Question

Consider a market in which suppliers know of a potential quality control problem associated with a good. Buyers are unaware of the quality issue.

A. Use a diagram to show how this situation affects the market.

B. Explain how the government could potentially intervene in this market and how doing so would affect social surplus.

Answer 1

(A) When suppliers are aware of a quality problem, this gives rise to a marginal external cost (MEC), which is added to the private marginal cost (PMC) to arise at social marginal cost (SMC), which is the relevant cost when the potential quality problem is recognized. When it is not recognized, market clears at intersection of the marginal benefit (MB or demand) curve and PMC curve. Therefore market price is lower and market quantity is higher than the outcome where full information is available to buyers as well.

In following graph, market outcome is at point A where MB and PMC intersect at with price P0 and quantity Q0. But efficient, full-information outcome is at point B where MB and SMC intersect with price P1 (> P0) and quantity Q1 (< Q0).

(B) Government could intervene by imposing a tax equal to the vertical distance between SMC and PMC curves, at efficient output level. In above graph, the unit tax is vertical distance BC.