Suppose that our local power station burns coal to generate electricity. The demand and supply functions for electricity are given by P = 10 - (1/2)Q and P = 2 + (1/2)Q, respectively. However, for each unit of electricity generated, there is an externality. When we factor this into the supply side of the market, the real social cost is increased, and the supply curve is P = 4 + Q.

Use the graph given below to answer the following questions.

Demand

a)Graph the demand, the free market supply and the supply with the externality.

b)What is the free market equilibrium level of production?

Free Market Equilibrium Quantity =

0

units

c)What is the efficient (i.e, socially optimal) level of production?

Socially Optimal Quantity =

0

units