Question

Question B2: Corrective taxes [25 marks] A firm uses two dirty inputs, i and y, which contribute to output a(z,y) and external harm H(x,y). The output price is p and the price of each input is equal to one. a) The socially efficient levels of the two inputs are those that maximise the firm's profits minus external harm, pu(x, y) - x - y - H(x, y). Take first-order conditions with respect to x and y. b) Next, consider the firm's profit maximisation problem. First, assume that output cannot be taxed, but both inputs can. If the input taxes are T, and Ty respectively, the firm maximises pax, y) - (1 + T) - (1 + Tyy. Take first-order conditions with respect to a and y. What should T, and Ty be set to, to implement social efficiency? c) Now imagine that neither input can be taxed, although output q can be. If the tax on each unit of output is Tg, what will the firm maximise? Take first-order conditions with respect to x and y. d) Under what conditions will it be possible to implement social efficiency with an output tax alone? Explain.

Answer 1

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