Question

Using a supply and demand diagram, demonstrate how a negative externality leads to market inefficiency. How might the government help to eliminate this inefficiency?

Answer 1

When negative externality exists in the market , the social cost is greater than the private cost. The market equilibrium quantity of Q0 is where private cost equals social benefit (or private benefit) and socially optimal quantity of Q1 is where social cost equals social benefit curve. The market equilibrium quantity will be greater than the socially optimal quantity in case of negative externality. So, the government could help to eliminate this inefficiency by taxing the product . The size of the per-unit tax must be equal to external cost to fully eliminate the effect of negative externality, here the per -unit tax would be equal to P3 - P1. (distance between social and private cost).