Q3.
Consider the production and consumption of widgets. Suppose the consumption of widgets causes a
negative externality.
a. Illustrate the externality problem in the widget market using a supply-and-demand diagram. That
is, draw and label the private marginal value (MV) curve, the social marginal value (SMV) curve, the
private marginal cost (MC) curve, the social marginal cost (SMC) curve, the market equilibrium level
of output ($Q_{LF}$), and the efficient level of output ($Q_{EF}$).
b. Using the same diagram, explain why the existence of the externalities causes market failure.
c. Use your diagram to show and explain how to use a \"corrective tax/subsidy\" to solve the
externality problem.