John R. Swinton, Ph.D. Center for Economic Education Georgia College & State University

Question: Assume that the market for good X is perfectly competitive and that the production of good X creates a negative externality.

(a) Draw a correctly labeled graph of the market for good X and show each of the following: Quantity good X Price good X Demand (or MB) 0

(i) The marginal private cost and the marginal social cost for good X, labeled MPC and MSC, respectively. Quantity good X Price good X Demand (or MB) 0 MPC MSC

(ii) The market quantity, labeled Qm. Quantity good X Price good X Demand (or MB) 0 MPC MSC Qm Pm

(iii) The allocatively efficient quantity, labeled Qs. Quantity good X Price good X Demand (or MB) 0 MPC MSC QmQs Pm Ps

(iv) The area of deadweight loss, shaded completely. Quantity good X Price good X Demand (or MB) 0 MPC MSC QmQs Ps Pm DWL

(b) Assume a lump sum tax is imposed on the produces of good X. What happens to the deadweight loss? Explain Quantity good X Price good X Demand (or MB) 0 MPC MSC QmQs Ps Pm DWL MPC + Tax Unit Tax

Traditional (A.C. Pigou) Approach: Identify Externality Impose a tax (or subsidy) that requires producer to internalize the external cost (or benefit) New price (MPC + Tax) represents the true cost to society of producing the good

Three Different Types of Taxes: Tax on offending product (Good X) = Pigouvian Tax Tax on input into production process that causes the externality (e.g. Gasoline Tax) Tax on the pollutant itself (e.g. Carbon Tax)

Alternative Approaches to Externality: Liability Law (e.g. Erin Brockovich) Well-defined Property Rights (Coase theorem) Limited Property Rights (e.g. Tradable Pollution Permits)