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2. Market solutions to correct for negative externalities This problem asks you to examine the costs in the market for gasoline. The cost of consuming gasoline comes in two parts: 1. First, the driver pays the market price for a gallon of gasoline. 2. In addition, other people who live in the area bear a cost because they suffer from the pollution created by consuming gasoline; this is the external cost of consuming gasoline Because external costs result from the consumption of gasoline, the marginal social cost of gasoline exceeds the marginal private cost. The following graph shows the demand for gasoline, the marginal private cost of a gallon of gasoline, and the marginal social cost of producing and consuming gasoline. o! Demand 10 20 304060 QUANTITY (Millions of gallons of gasoline)

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If the government does not intervene in the market, then the drivers equilibrium will be at the point where the marginal private cost is equal to the demand curve Demand Equilibrium without Government intervention 10 20 30 40 50 70 Quantity Therefore, if the government does not intervene in the market for gasoline, the equilibriunm price will be S2, and drivers will buy 40 millions of gallons of gasoline. It is evident from the graph above that marginal social cost (Ssoca of gasoline is greater than the marginal private cost ). Therefore, the first statement is correct. At the market quantity, marginal private cost of gasoline is $2. However, the market price should have been $4. Thus, the second statement is incorrect The market outcome is where 40 million of gallons of gasoline is produced. However, the socially efficient amount would have been 20 million. Therefore, the market outcome is not socially efficient, and the third statement is correct The efficient level of gasoline is 20 million. Thus, the society prefers 20 million of gasoline However, the market outcome of gasoline is 40 million. Thus, society prefers lesser gasoline than the market outcome and therefore, the fourth statement is incorrect. The statements which correctly describe the market for gasoline are:

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