Question

Assume that the demand for a product is Q = 1,200 – 4P and supply is Q = –200 + 2P. However, the production of this product emits pollution that has a marginal external damage of $8 per unit.

1. If the government were to impose a tax paid by firms for every unit produced, what tax amount per unit would yield the socially optimal quantity produced in equilibrium?

B) If the government were to impose a sales tax, paid by consumers, on every unit purchased, what tax amount per unit would yield the socially optimal quantity consumed in equilibrium

Answer 1

Marginal external damage cost = Externality cost of $8 per unit

As per the Pigouvian tax imposed in case of externalities, in order to correct for externalities and reduce output to the socially optimal level, the tax imposed on either side of the market must equal to the marginal damage cost or externality cost imposed.

In the given case, since the cost of externality per unit is $8, tax imposed would also be $8

a)

Tax imposedo on sellers = $8 per unit

b)

Tax imposed on consumers = $8 per unit