Question

Problem 1: Externalities (20 points) Figure 1 shows the marginal private benefit from college education at an imaginary college. The marginal cost of a college education in this example is a constant $6,000 per year. The marginal external benefit from a college education is $4,000 per student per year. FIGURE 1 $10,000 $9,000 $8,000 $7,000 PRICE OF TUITION $6,000 $5,000 $4,000 $3,000 $2,000 1,000 1,500 2,000 4,000 4,500 5,000 2,500 3,000 3,500 STUDENTS PER YEAR a) If colleges were private and government had no involvement in college education, how many people will undertake a college education, and what will be the tuition? b) What is the efficient number of students? c) Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies vouchers and patents can achieve a more efficient outcome.

Answer 1

(a)

Unregulated market equilibrium is when MPB = MC = 6,000.

Equilibrium number of students = 3,000

Tuition = $6,000

(b)

Socially efficient outcome is achieved when MSB = MPB + MEC = MC

MSC = MPB + 4,000.

In following graph, socially efficient outcome is at point B where MSC intersects MC with efficient number of students 5,000 and tuition $6,000.

FIGURE 1 $10,000 $9,000 MSB $8,000 57,000 MC PRICE OF TUITION $6,000 55.000 $4,000 MPB 53,000 $2.000 1.000 1.500 2,000 2.500 3.000 3,500 STUDENTS PER YEAR 4,000 4.500 5,000

(c)

Education generates positive externality. If this external benefit is not internalized, the market continues to set a lower-than-efficient tuition fee and admits a lower-than-efficient number of students. If, for example, the government offers a subsidy, it increases student enrolment, increasing demand until socially efficient outcome is obtained.