Question

4. (10) The Pigouvian Approach to Externalities The following diagram displays a negative consumption externality, smoking. Note that, in contrast to the treatment of a negative production externality, the negative consumption externality is treated as causing a divergence between the marginal private benefit (MPB) of a cigarette and its marginal social benefit (MSB). The price on the y- axis is the consumer price. Assume that there are no production externalities, MSC MPC, and that S-$-S. Recall that the cigarette industry supply curve is its MPC curve. MSB MPB a) (2) In what units is deadweight loss measured? b) (2) Using the diagram, illustrate the Pigouvian policy that would be applied to deal with the negative consumption externality c) (2) Give the rationale for the Pigouvian policy d) (2) Indicate one weakness of the Pigouvian policy e) (2) The way the diagram is drawn assumes that the difference between MPB and MSB is independent of q. What is the economic interpretation of this assumption?

Answer 1

a) In this case the dead weight loss due to externality will be area XGJ. The welfare loss due to externality is the dead weight loss. Here total value of the area triangle XGJ will be equal to 1/2*WV*JG. The dead weight loss is measured by dollars. Here JG is the amount of negative externality that occurs from consumption and this amount of negative externality will be taxed. So amount of per unit of tax is JG. Due to tax the change in quantity will be WV.

b). The pigouvian tax will be the amount equal to RX. This amount of tax will be imposed on consumer to internalize the tax. We can show it in following way-

a) In this case the dead weight loss due to externality will be area XGJ. The welfare loss due to externality is the dead weight loss. Here total value of the area triangle XGJ will be equal to 1/2*WV*JG. The dead weight loss is measured by dollars. Here JG is the amount of negative externality that occurs from consumption and this amount of negative externality will be taxed. So amount of per unit of tax is JG. Due to tax the change in quantity will be WV. b). The pigouvian tax will be the amount equal to RX. This amount of tax will be imposed on consumer to internalize the tax. We can show it in following way RX = Amount of Negative tax RX = p_1 p_2 = pigouvian tax. c) Pigouvian tax actually helps to reduce the negative externality because when we impose tax equal to P1P2 consumer will be discouraged from there to consume. Another thing is that it creates efficiency in the economy. Because the consumer paying taxes for damage it creates.

c) Pigouvian tax actually helps to reduce the negative externality because when we impose tax equal to P1P2 consumer will be discouraged from there to consume. Another thing is that it creates efficiency in the economy. Because the consumer paying taxes for damage it creates.

d) The one weakness of pigouvian tax is that it is regressive in nature. As there is fixed per unit of tax is imposed then the tax is comparatively high for lower income group than the higher income group. Let suppose $10 tax is imposed then whose income is $100 and whose income is $1000 dollars will not have same impact.

e) In the diagram MPB and MSB are independent of q. It means negative externalities will not be varies with how much consumption the consumer is doing. The externality does not vary with demand. As we know quantity demand depends on price and here this simple relation follows. In MPB the benefit depends on price. Actually consumption externality does not have any change with quantity and it has only linear relationship. It is not proportionately with quantity.