CIMA BA1 · Chapter 8 · Question 6 of 9
In a market, demand (marginal social benefit) is P = 120 - Q and marginal private cost is P = 20 + Q. Production causes a constant marginal external cost of $20 per unit. What is the socially optimal output?
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: C) 40 units
Explanation
Marginal social cost = marginal private cost + external cost = 20 + Q + 20 = 40 + Q. The social optimum is where MSB = MSC: 120 - Q = 40 + Q, so 2Q = 80 and Q = 40 units. The free market output, ignoring the externality, is where 120 - Q = 20 + Q, i.e. 50 units, so the market overproduces by 10 units.
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