Question

6. Markets fail when allocative efficiency is not achieved; when a factory emits toxic smoke, a negative externality is created. Why do economists justify a tax to penalize the factory in this case? (10 marks)

Answer 1

Ans) Negative externality is when the bystander bears the cost of any activity. Eg- pollution. Here social cost is more than private cost. The difference between social cost and private cost is known as external cost. When this external cost is ignored, goods are overproduced. To internalise this externality government imposes tax equal to external cost.

Tax on suppliers will shift the supply curve to the left. This increases the price paid by buyers and reduces the price received by sellers. Due to increase in price paid by buyers, quantity demanded decreases and due to decrease in price received by sellers, supply also decreases. As a result, net quantity exchanged is reduced and is brought down to optimal level.