Question

Using a diagram, explain how an external cost of production (i.e. a negative production externality) can be internalised with a tax.

Answer 1

A negative production externality increases private marginal cost (PMC) by the amount of marginal externality cost (MEC), therefore the marginal social cost (MSC = PMC + MEC) curve lies to the left of PMC curve. Market equilibrium is at intersection of PMC and Demand curves, and socially efficient outcome is at intersection of MSC and Demand curves with higher price and lower output. This externality can be internalized using a (Pigouvian) tax equal to the MEC.

In following graph, Market equilibrium is at intersection of PMC and Demand curves at point A with price P0 and output Q0, and socially efficient outcome is at intersection of MSC and Demand curves at point B with higher price P1 and lower output Q1. The per unit Pigouvian tax is equal to the vertical distance BC.

MSC PM C A D 90