Market Failure and Externalities: Question 1

Worked solution

Step 1: Recall the relationship between social, private and external cost

Marginal social cost (MSC) is the total cost to society of producing one more unit. It is made up of two parts: the marginal private cost (MPC), which is the cost borne directly by the producer (here, the tannery), and the marginal external cost (MEC), which is the additional cost imposed on third parties (here, the rice farm) that the producer does not pay. A negative externality adds an extra cost on top of the private cost, rather than replacing or reducing it, so: $MSC = MPC + MEC$

Step 2: Check option B

Option B states this correctly: $MSC = MPC + MEC$. This matches the definition above. The tannery’s own production cost (MPC) plus the uncompensated cost imposed on the rice farm (MEC) gives the true social cost (MSC).

Step 3: Rule out A, C and D

• Option A ($MSC = MPC - MEC$) incorrectly subtracts the external cost, which would mean a negative externality somehow makes the social cost of production lower than the private cost. The opposite of what a negative externality means.
• Option C ($MSC = MPB + MEC$) confuses marginal private benefit ($MPB$, a demand-side concept) with marginal private cost; benefit and cost are entirely different concepts on opposite sides of the market.
• Option D ($MEC = MPC + MSC$) rearranges the terms incorrectly. Since $MSC$ is the total that is built up from $MPC$ and $MEC$, it cannot also be added to $MPC$ to give $MEC$, which is by definition the smaller, external-only component.

Final answer

Option B. $MSC = MPC + MEC$: marginal social cost equals the tannery’s marginal private cost plus the marginal external cost imposed on the rice farm downstream. Option A reverses the sign, and options C and D mix up unrelated or incorrectly rearranged terms.