Question

9 marks How can taxes be used to increase efficiency when there are externalities? Explain your answer using a diagram. 9 marks Under what conditions can externalities be eliminated by the allocation of property rights?

Answer 1

1.

Taxes can be used to eliminate the negative externality, because it helps make MSC = MSB in the market. For example, a firm produces output and sell it at a lower price because firm incurs only marginal private and it does not consider the external cost in terms of pollution and create negative externality. It creates market failure, despite achieving market equilibrium. To correct the situation, the government puts tax (also named as Pigovian Tax) on output to be produced. It causes supply curve to shift to the left and socially optimal equilibrium is achieved. It is demonstrated as follows.

S1 = SMC Price S=PM с E External cost P2 P1 D= PMP SMB Q2 Q1 Output

At Point E, socially optimal equilibrium is achieved when external cost as tax is applied to make SMC = SMB. It makes price to be at P2 and out decreases to be Q2 at E.

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2.

When the goods are public goods or the goods are common resource goods, then there is a problem of free rider and tragedy of the commons respectively. In these conditions, if private property rights are allocated, then it leads to sincere use of the resources that brings conservation and longevity. As a result, market failure is prevented.