Graphing Exercise: Spillover Effects

A spillover effect is a cost or benefit accruing to a person or group of people who are external to a market transaction. When this occurs, the market fails to provide an optimal quantity of the good or service. Too little is produced in the case of spillover benefits; too much in the case of spillover costs. In some instances, government intervention may be required to correct the market failure.

The graph shows a competitive market in equilibrium. Private benefits and costs are reflected in the demand and supply curves labeled D and S, respectively. The price is $50 and 40 units are sold each period. Click anywhere inside the boxes labeled Spillover Benefit or Spillover Cost and enter a value. Spillover benefits are assumed to accrue to consumers while spillover costs are assumed to accrue to producers. If there are spillover benefits, the curve labeled D_t illustrates the total benefit to society of each successive unit of the good - the private benefit plus the spillover benefit. Likewise, the curve labeled S_t reflects the total marginal cost of the good - the private and the spillover cost - in the event of a spillover cost. To simulate a government policy, drag either the demand curve or the supply curve in the appropriate direction to correct for the market failure, then click on the New Equilibrium button to observe the market adjust to the policy. Click Reset to restore the initial values.

1		Suppose production of this good imposes spillover costs of $10 for each unit produced. Does this cause too much or too little production of this good? How might the government respond to correct this market failure?
2		Suppose production of this good provides a spillover benefit of $10 for each unit produced. What is the optimal quantity in this market? How might the government respond to correct this market failure?