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MARGINAL PRIVATE BENEFIT & MARGINAL PRIVATE COST

Generally, the marginal private benefit (MPB) corresponds to the demand of a good (D). In fact, a
demand curve reveals how much a private consumer is willing to pay for each extra unit of
consumption: obviously, the consumer's marginal willingness to pay is determined by the marginal
benefit he gets from each extra unit of consumption. Therefore, it is possible to say that MPB=D.

Similarly, the marginal private cost (MPC) corresponds to the supply of a good (S). In fact, the supply
curve reveals how much a private producer is willing to charge for each extra unit of production:
clearly, the producer's willingness to charge is determined by the marginal economic cost he has to bear
in order to produce each extra unit of production. Therefore, it is possible to say that MPC=S.

POSITIVE EXTERNALITIES

Normally, positive externalities are generated when the consumption of a certain good yelds a social
benefit that is greater than then private one at all output levels. In other words, the individual demand
of a good benefits not only the sole consumer but also the other members of society. An example in this
direction is education: not only those who receive education will benefit from it, but also society as a
whole will benefit from having one more educated person that can then find better solutions, be more
productive, and all sorts of similar things.

This situation can be represented by a market in which the marginal social benefit is greater than the
marginal private benefit (which is actually equal to the demand curve). While on the supply side, we
assume that the production does not impose any cost on society different from the private one.
In the graph above the market would produce at the private equilibrium point (i.e. the point where
MPC=MPB, at (p1,q1)). However, at such point MSB≠MSC (due to MSB>MPB), which means that
the socially efficient equilibrium point is not reached (i.e. the point where MSB=MSC, at (p2,q2)).
Obviously, being this a merit good, society would like to have more of it (that's why q2>q1). In such
case, the merit good is then under provided.

What can be done to give to society the socially efficient quantity q2? Basically, there are two options:
either the government subsidizes (per unit) the producers to sell the good more cheaply, or it subsidizes
(per unit) the consumers to allow them to purchase a greater quantity of the merit good. Let's look at
these two options separately.

Per unit subsidies to the consumer.

An example of subsidies to the consumers aimed to filling the gap caused by positive extrnalities could
be the provision of state scholarships.
At each level of consumption, consumers get a subsidy that is equal to the per unit positive externality.
With the money of the subsidy they will then be willing to pay a greater price for the merit good, which
in turn leads the demand curve to increase and reach the socially efficient level at which MSB=MSC.

Per unit subsidy to the producer.

An example of subsidies to the producers aimed at filling the gap caused b a positive externality could
be subsidies for the private provision of renewable energies.
At each level of production, producers get a subsidy that is equal to the per unit positive externality.
With that money they will then be willing to charge a lower price for the merit good, which in turn lead
the supply to increase up to the quantity (q2) at which MSC1=MSB.

NEGATIVE EXTERNALITIES
Normally, negative externalities are generated when the production or the consumption of a certain
good generate a marginal social cost that is greater than the marginal private cost at all output levels.
Some easy examples are pollution, cigarettes, or alcohol. For instance, when a production is polluting
the cost it creates are not only the private one born by the producers: there are also some social cost
such as the deterioration of natural resources (air, rivers, land), or the health problems that pollution
might cause to people.

This situation can be represented by a market in which the marginal in which the marginal social cost is
greater than the marginal private cost, which is actually the supply curve. While on the demand side,
we assume the marginal private benefit to be equal to the social one.

In the graph above the market would produce at the private equilibrium point (i.e. the point where
MPC=MPB, at (p1,q1)). However, at such point the social equilibrium point would not be reached (i.e.
the point where MSC=MSB, at (p2,q2)). Clearly, being this a demerit good, society would like to have
less of it (that's why q2<q1). In such case the demerit good is then over provided.

What can be done to give society the socially efficient quantity q2? Normally, the answer is that the
government might decide to impose a tax on the good. Such tax would act necessarily on the supply
curve, regardless of whether the negative externality derives from production (like in the case of
pollution) or from consumption (like in the case of cigarettes).
The government would simply impose a tax on the good, which would make the good more expensive
for each quantity level. Consequently, the supply curve would decrease and the quantity allocated by
the market would then reach the social efficient level at which MSC=MSB.