Question

A) Suppose a factory owner is permitted to pollute the environment without any restrictions, draw a picture of the equilibrium that would emerge for the good they sell (if there was no government involvement in the market) as well as the socially optimal equilibrium (assuming that the pollution imposes an external cost). a) Put both equilibriums on the same graph and label them both. b) Label all curves. c) Label the DWL associated with the equilibrium.
B) How might a tax improve the efficiency in the market described above in (1) -- even if the government does not precisely know the external cost associated with the externality? Explain and show this in a new diagram

Answer 1

Answer Pollution in an economy empoant external cost to the economy as it is ě negative externality. The equilibrium or optimal level of pollution is the level of pollution that maximizes social welfare with respect to the quality of the environment. The equilibrium live is reached when the marginal cost of Pollutions (MC): cost of pioduring an extra linit of pollution is equal to the Marginal Benefit of Pollution (MB) : benefit received from producing an extra unit of pollution. . Since pollution is a negative externality, the marginal Cost will increase with using level of pollution and the marginal benefit will fall with the level of pollution. While, making decisions about the lid of pollution, fums consider only the Marginal Priscate cost in the absence of gevernment. However, the told Marginal Social cost (msc) to the society is actually the sum of MPC and Marginal External cost (MEC). The socially optimum level of production is when MB is equal to Misc and not MPC. Ion the absence of government intervention, sto equilibri equilibrium is at MB = MPC This can be shown in the diagram, as follows:

MB, MC, MSc = MPC +MEG TMEC MPC deadweight loss ----KER MEC MEC 1 i MS Level of production If there is no government intervention : MB = MPC [ Ep] oft equilibrium lend of production or socially optimum level of production : MB = MSc = MPC+MEC [Es] equilibrium level of production t o Since pollution is a negative externality, deadweight loss is towards the right of the socially optimal land and is equal to area of the shaded region in the diagram which is equal to [ + x (Bi" - Q) x MEC] (b) A pigourian tax can improve the efficiency in the market. A pigourian tax is a tax on gooo that I have negative externality to discomage individuals from taking the action. Negative externalities impose external cost to society that an individual ignores while making decisions. A pigouvian tax tries to offect their cord by increasing the puvate cost equal to social cost of the action !

It follows the simple idea of law of demand and supply. Tax uncreases the cost of producing addition units of commodity (Mc) and therefore, shifts the MPC curre upward to the new level such that MPC = MSc where MPC is the new level of Marginal Revate cost Let the tax be equal to tpu unit of production. MB, MC -MPC'= MPCHE MPC PD MB o & g" sevel of production, &p aa 8 Р The implementation of Pgouvial tax raises the maigual cost and reduce production, in effect reducing pollution and generating revenue for government to invest in pollution abatement policies. It also removes the deadweight loss. Even if the government doesn't know the exact to put t=mEc, tax would still improve efficiency tLMEC. MEC if