Question

3. Using a diagram, demonstrate and explain how taxation might be used to provide a more socially efficient level of output in the presence of a negative externality in production. (8 marks)

Answer 1

3. I have used a diagram to demostrate how taxation might be used to provide a more socially efficient level of output in the presence of a negative externality in production.

Below is the diagram, where Price is plotted on the vertical axis and Quantity is plotted on the horizontal axis. The Demand is the downward sloping curve which is also equal to the Private Marginal Benefit Curve (PMB) = Social Marginal Benefit curve (SMC). The Social Marginal Cost curve (SMC) is greater than the Private Marginal Cost (PMC) Curve because of the presence of negative externality.

The free market equilibrium without government intervention has equilibrium quantity, Q1 and equilibrium price, P1 but we see that Q1 quantity is greater than the socially efficient quantity, Q2. So, here the government intervenes and imposes a tax equal to the social cost incurred and the tax is of the amount P2P0 as shown in the diagram below. This leads to increase in the equilibrium price from P1 to P2 and the equilibrium quantity also decreases from Q1 to Q2.

Price Marginal Social Cost Marginal Private Cost P2 TAX P1 РО Demand 0 Q2 Q1 Quantity