Draw a diagram of the supply and demand curves for telephone
service. The marginal cost of connecting another household to
the telephone network is increasing, as it is more costly to connect another household as the size of the network grows larger.
Assume that the demand curve is downward sloping.
a. Label the market equilibrium in your diagram EMKT.
Telephone service is a positive externality (sometimes called a
“network externality”). There is a marginal external benefit to
connecting one more household to the telephone network, the
benefit to everybody else of being able to call the newly connected household.
b. Draw the marginal social benefit curve into your diagram,
find the socially optimal point, and label it O.
c. Explain why the market equilibrium EMKT is inefficient.
d. Governments subsidize phone service for rural households. Describe how such a Pigouvian subsidy eliminates
the inefficiency.