Define PMB and PMC1. The Private Marginal Cost measures the cost to producers for every additional unit of oil produced, such as the cost of raw materials, of labour, mining.

2. The Private Marginal Benefit measures the benefit to consumers from every additional unit of steel consumed

Mention that external costs are not considered 3. However, external costs are generated to third parties who are not part of the production or consumption process.

Mention specifically the external cost4. For each unit of oil burnt, toxic fumes are released to the environment which are inhaled by third parties living near the factories, leading to a higher incidence of respiratory diseases and medical expenses.

Mention that costs are borne by third particles and no compensation is given5. These costs are borne by the third parties themselves (society/employers) and are not compensated by the oil burners.

Mention the type of externality6. Therefore this leads to a negative production externality, since external costs are unpriced by the price mechanism.

Elaborate on SMC7. For each additional unit of oil burnt, the SMC measures the PMC and external cost on third parties. Hence, actual cost borne by society is the SMC curve.

Start explaining the externality graph8. As shown in the figure, the presence of external costs causes a divergence between PMC and SMC, with SMC ABOVE PMC as SMC=PMC+EMC

Assumption CP9. Assuming EMB=0(no negative externalities), thus PMB=SMB

Market Equilibrium10. Assuming market equilibrium quantity of oil is at Q, where PMB=PMC.

Social Efficient11. However, the socially efficient quantity is at Q1,where smc = smb, where the external costs to society is taken into consideration.

Overproduction12. Since Q1 is < Q, overproduction occurs by Q-Q1

Mark out area for total social cost and benefit_____ ________

Explain Deadweight loss13. Since total social cost incurred outweighs total social benefits gained, area ___ represents the total deadweight welfare loss due to overproduction.

Mention about Price14. Also, at the market equilibrium, price is at P, but socially efficient price should be equal to SMC at P prime. Therefore, free market has overpriced the burning of oils since Pm < Pm prime.

Market Failure15. Inefficient allocation of resources, overallocation, leading to market failure.

Mention policy1. Pigouvian tax can be implemented.

How tax affects PMC2. Tax at EMC at Q1 shifts PMC upwards such that at the new PMC, which equals PMC+TAX, coincides with the SMC at QS.

Market Equilibrium3. Hence, new market equilibrium considers in the external costs, quantity where PMB=PMC + Tax now coincides with the socially efficient quantity Qs where SMB=SMC.