Scarcity is the basic economic problem that arises since people have unlimited wants but limited resources. Hence, economic decisions must be made to allocate resources efficiently. In this topic, the role of profit in a market economy would be analyse below. Profit plays an important role in economy, it is a motivation for production activity assumed by an organisation. Every company tries to minimize their cost and maximizing their profit. This means that, profit can be an indicator for business to allocate their resources. Hence, firm can put their resources into a market that able to help them generates profit. Moreover, organisation will produce at where the market demand (Marginal revenue, MR) intersects market supply
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If a company produce their quantity at A where the demand is greater than supply, then this means that business did not meet the market demand because MPB>MPC means that the business is not producing efficiently and obviously the business should produce more. Furthermore, it also means that the firm is not maximizing its profit. Therefore, the business should increase its production to equilibrium quantity, point B. When firm produces their product at quantity C we could observe that the demand is lower than supply. This implies that business should produce less for this particular product and reallocate their resources more efficiently as MPC>MPB.
Mathematically, marginal social benefit is equals to marginal private benefit (demand) plus marginal externalities benefits (MSB=MPB (D) + MEB). And marginal social cost is equals to marginal private cost plus (supply) marginal externalities cost (MSC=MPC (S) +MEC).
The graph below illustrates production of cigarette in a market. Cigarette is a demerit good and it exhibits negative externalities from consumption, such as air pollution and lung cancer. In the free market, it ignores the spillover cost associated with cigarettes and it only takes into account its private cost and private benefits. The existing of negative externalities will cause the social cost greater than private cost. As MSC= MPC+ MEC, it will leads to a shift of MPC curve to