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Consumer Surplus, Producer Surplus and Correcting for Spillover Costs or Externalities

Question 1. Draw a supply and demand graph and identify the areas of consumer surplus and producer surplus. Given the demand curve, what impact will an increase in supply have on the amount of consumer surplus shown in your diagram? Explain why?

Question 2. Why are spillover costs and spillover benefits also called negative and positive externalities? Show graphically how a tax can correct for a negative externality and how a subsidy to producers can correct for a positive externality. How does a subsidy to consumers differ from a subsidy to producers in correcting for a positive externality?

Solution Preview

Question 1: The gain of consumer and producer from the trade is called consumer surplus and producer surplus respectively. The Consumer's Surplus is the difference between what the consumer would be willing to pay and what the consumer actually pays to acquire a given quantity of a good. An increase in supply has a positive impact on amount of consumer surplus. Rise in supply will lower the price that will increase in the quantity traded in the market. It results in increase of the amount of consumer surplus for a given demand curve. Any individual, who was receiving consumer surplus before the change in supply will realize an increase in consumer surplus due to fall in price as supply ...

Solution Summary

The expert examines producers surplus and correcting for spillover costs or externalies. How subsidy to consumers differ from a subsidy to producers in correcting for a positive externality is determined.

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