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15. Assume the demand curve for a good is perfectly inelastic and the productio...

Jan 29, 2024

15. Assume the demand curve for a good is perfectly inelastic and the production of each unit of this good generates external costs. A profit-maximizing firm producing the good in an unregulated free market will (A) generate deadweight loss because marginal social cost is greater than marginal private cost. (B) generate deadweight loss only if marginal costs are constant (C) not generate deadweight loss because the equilibrium quantity is socially optimal (D) not generate deadweight loss unless marginal costs are constant (E) not generate deadweight loss unless fixed costs are zero

Key Concept

External Costs and Deadweight Loss

Explanation

When a firm's production generates external costs, the marginal social cost (MSC) of producing the good is higher than the marginal private cost (MPC). In a perfectly inelastic demand scenario, the quantity demanded does not change with price. A profit-maximizing firm will produce where marginal private benefit equals marginal private cost, ignoring the external costs. This results in a quantity where MSC > MPC, leading to a deadweight loss because the social optimum is not achieved.

deadweight lost

Answer

A profit-maximizing firm producing a good with perfectly inelastic demand and external costs will generate deadweight loss because marginal social cost is greater than marginal private cost.

Solution

Perfectly Inelastic Demand: When demand is perfectly inelastic, the quantity demanded does not change regardless of the price

External Costs: External costs are costs that are not borne by the firm but by society. They cause the marginal social cost (MSC) to be higher than the marginal private cost (MPC)

Deadweight Loss: Deadweight loss occurs when the market equilibrium is not socially optimal, which is the case when MSC is greater than MPC

Profit-Maximizing Firm: A profit-maximizing firm in an unregulated market will produce where its marginal private cost equals marginal revenue (MPC = MR). This does not account for the external costs, leading to overproduction and deadweight loss

Key Concept

Deadweight Loss from External Costs

Explanation

In the presence of external costs, the social optimum is not achieved because the firm does not consider the external costs in its production decision, leading to a quantity where the marginal social cost exceeds the marginal private benefit, resulting in deadweight loss.

MSC

In this scenario, we are discussing the concept of deadweight loss in relation to a profit-maximizing firm producing a good with a perfectly inelastic demand and external costs. The student asked about the relationship between deadweight loss and marginal social cost (MSC). The correct answer is indeed choice A. A profit-maximizing firm producing a good with perfectly inelastic demand and external costs will generate deadweight loss because the marginal social cost is greater than the marginal private cost. Deadweight loss occurs when the quantity of a good produced is not at the socially optimal level. In this case, the firm is not taking into account the external costs associated with production. The marginal social cost includes both the private cost to the firm and the external costs imposed on society. Since the firm is only considering the marginal private cost, it will produce more than the socially optimal quantity, leading to deadweight loss. I hope this clarifies the concept of deadweight loss in relation to marginal social cost. Let me know if you have any further questions!