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Consider the case of a positive consumption externality.
A. Suppose throughout this exercise that demand and supply curves are linear, that demand curves are
equal to marginal willingness to pay curves, and that the additional social benefit from each consumption
unit is and is constant as consumption increases.
a. Draw two graphs with the same demand curve but one that has a fairly inelastic and one that has
a fairly elastic supply curve. In which case is the market output closer to the optimal output?
b. Does the Pigouvian subsidy that would achieve the optimal output level differ across your two
graphs in part (a)?
c. Draw two graphs with the same supply curve but one that has a fairly inelastic demand curve
and one that has a fairly elastic demand curve. In which case is the market output closer to the
optimal output?
d. Does the Pigouvian subsidy that would achieve the optimal output level differ across your two
graphs in part (c)?
e. True or False: While the size of the Pigouvian subsidy does not vary as the slopes of demand
and supply curves change, the level of under-production increases as these curves become
more elastic.
f. In each of your graphs, indicate who benefits more from the Pigouvian subsidy: producers or
consum
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