Holt 7525-9 S15_IT

External Benefit
If a market generates an external benefit, the private market will underproduce compared to the
optimal quantity. Marginal social benefit will be equal to marginal private benefit plus marginal
external benefit.
Example 1B: Assume the same facts as Example 1A, except that now the market generates an
external benefit of $20 for each unit consumed. The table below indicates marginal private cost
(MPC), marginal private benefit (MPB), marginal external benefit, and marginal social benefit
(MSB) for different quantities of output. Marginal social benefit is the sum of marginal private
benefit and marginal external benefit. The graph below illustrates that private market equilibrium
(where MPB = MPC) occurs at a quantity of 4 units and a price of $45. The optimal quantity
(where MSB = MSC and labeled OPT) occurs at 5 units, which corresponds to a price of $55.
Quantity MPC MPB Marginal External Benefit MSB
1 $15 $75 $20 $95
2 25 65 20 85
3 35 55 20 75
4 45 45 20 65
5 55 35 20 55
6 65 25 20 45
7 75 15 20 35
$
$95 -
85 -
75 -
65 -
55 -
45 -
35 -
25 -
15 -
Z
0
0 1 2 3 4 5 6 7
P.M.E.
Quantity
OPT
S MPC
D MSB
D MPB
With an external benefit, the private market equilibrium (where MPB = MPC) will be less than the
optimal quantity (where MSB = MSC).
External Cost
FOR REVIEW ONLY - NOT FOR DISTRIBUTION
If a market generates an external cost, the private market will overproduce compared to the
optimal quantity. Marginal social cost will be equal to marginal private cost plus marginal external
cost.
27 - 3 Market Failure