Question

market fail when allocative efficiency is not achirved; when a factory emits toxic smoke, a negative externality is created. why do economists justify a tax to penalize the factory in this case?

Answer 1

Ans) Externality is when the bystander bears the cost or benefit of any activity. It is of two types ÷ positive and negative.

Negative externality is when the bystander bears the cost of any activity. 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 by the market. So, in order to internalise this externality, government imposes tax equal to external cost.

Tax reduces the supply and supply curve shifts to the left. This increases price while it decreases quantity. That is, when a tax is imposed, price increases (price paid by buyers increases and price received by sellers decreases). This increase in price paid by buyers discourage quantity demanded and the decrease in price for sellers decreases supply of goods and hence quantity exchanged is reduced and brought to the optimal level.