Positive Externalities Problem #1

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Positive Externalities Problem #1 ( points)

Open the Externalities module and choose the positive externalities option. On the Initial Conditions page select “Continue.” (Disregard the numerical initial conditions shown, they refer to the results of a monopoly producer. You will not be acting as a monopolist so these conditions are not useful to you. However, the next page has a graph you might find useful.) On the graph page click “Continue.” On the next page do not change the development cost, just select “Market Structure” on the tool bar. Choose the Competition option and on the next page do not select either form of subsidization, just select “Continue” on the tool bar. In light of the message you see and the numerical results on the next page:

a)Why did you receive the message, how is its content related to the numerical results you received?

This table covers the answers for parts a through d.

The message was that under the circumstances in the long run there would be no vaccine. Since the industry could not even break even none would be produced. The numerical results indicate that the industry would be losing $500 (economic loss) and that means firms would leave the industry (or maybe would never enter and there never would be an industry in the first place).

b)Usually perfect competition in an industry means a socially efficient result. Is the result you got in this case socially efficient? Explain why or why not. (Strictly you got two results, one indicated by the message, the other by disregarding the message and just looking at price, production, etc. in the numerical results. Cover both results in your answer.)

If no vaccine is produced at all (as the message suggests) that is clearly not socially efficient. That would mean that potential social marginal benefits are greater than social marginal costs, at least some vaccine should be produced. Looking at the results that would occur if, in spite of the problem of economic loss, the competitive industry produced an amount of the vaccine that allowed marginal cost to equal price (supply equal to demand). At that point actual vaccinations would total 150, while the social optimum is shown as 250, so only about 78% of the optimum amount was produced. When production equals 150 marginal cost (private and social) is $10, equal to price, while marginal social benefit is equal to $40. In other words producing and administering another flu shot costs $10, adds $40 of benefits to society, and increases overall social well being by the net amount, $30, The competitive industry, even if it produces vaccines, is producing less than the socially efficient amount. In this case even perfect competition does not produce efficiency because to the difference between price (marginal private benefit) and marginal social benefit—which includes the benefit gained by those who are not vaccinated but who are less likely to catch the flu because other people were vaccinated.

c)What policy could you use to eliminate the message you got? Explain, and implement that policy to ensure that the policy works. Show the results in your answer. Is this result socially efficient?

Note that the amount of the economic loss by the competitive industry (which is the reason for the message) was $500, and that was the same as the cost of development of the vaccine. In fact it is the development cost that is the reason for the loss. In perfect competition price winds up equal to marginal cost in equilibrium. Marginal cost is the extra cost of producing one more unit of, in this case, vaccine. The original cost of developing a vaccine is not part of marginal cost. That means that a firm that paid anything toward developing a vaccine would not be able to charge enough to pay off that cost. (It could not charge other firms royalties to cover this, if it could get a patent in effect it would be a monopoly and that is the other market structure.) Therefore the thing that would eliminate the message and this problem would be to have the government pay the full cost of developing the vaccine. The result would be exactly the same as in (a) except that the economic profit for the industry is zero.

The result is still not socially efficient. It is better than not having any vaccine, but marginal social benefit is still much larger than marginal social cost, so the competitive industry is producing too little of the vaccine.

d)If you determined that your results in ( c) were socially inefficient what policy could you use to reach a better result? Explain, and implement that policy to ensure that the policy works. Show the results in your answer.

To get to a socially efficient result the industry still has to avoid economic losses, so the total subsidy for development is still needed. However, in addition the government can subsidize the actual vaccinations, paying part of the marginal cost of producing and distributing the vaccine. The larger the subsidy the lower the private marginal cost to firms and the more vaccine will be provided. When the government pays 75% of the $10 private marginal cost the competitive industry produced the social optimum, with MSB equal to MSC and Total Social Net Benefits at the (maximum) optimum level. The additional subsidy encouraged people to be vaccinated at a greater rate so the extra social benefits declines until they were equal to marginal cost.