The graph shows a typical competitive market in equilibrium. Private costs and benefits are reflected in the supply and demand curves labeled D and S, respectively. The price is $50 and 40 units are sold each period. To illustrate the effects of an external benefit, click inside the box labeled External Benefit and enter a value. The curve labeled Dt illustrates the total benefit to society of each successive unit of the good – the private benefit plus the external benefit. To illustrate the effects of an external cost, click inside the box labeled External Cost and enter a value. The curve labeled St reflects the total marginal cost of the good –the external and the private cost. To simulate a government policy such as a tax or subsidy, drag either the demand curve or the supply curve in the appropriate direction to correct for the market failure, and then click on the New Equilibrium button to observe the market adjust to the policy. Click Reset to restore the initial values.

Presume production of this good imposes external costs of $10 for each unit produced. Does this cause an over or an under allocation of resources to production of this good? How might the government respond to correct this market failure?

Presume production of this good provides an external benefit of $10 for each unit produced. What is the efficient quantity in this market? How may the government respond to correct this market failure?