Microeconomics 2nd Edition by Douglas Bernheim

Exercise 1

Students receive two types of benefits from standardized test preparation services: first, they learn useful material; second, they score better on the test relative to other students. Because relative performance matters, their improved performance creates a negative externality for other students. Suppose that the market demand function for test preparation services is Q d = 30 P/2, where Q d is millions of hours of services and P is the price per hour. Suppose also that the market for these services is competitive and that the market supply function is Q S = 2 P - 30. Finally, suppose that the external cost of test preparation is given by EC = 5Q + 0.75 Q 2. Find the socially efficient level of test preparation, the competitive equilibrium, and the deadweight loss created by the externality. Draw a figure to illustrate your answer.