Question

In reference to the optimal level of drug consumption, explain how the Pigou taxation solution works. (Hint: externality model)

Answer 1

Answer - The consumption of drug leads to the negative externalities in the society. This means that the supply will be more than optimal . Hence the difference between the market supply which brings in the negative externality and the socially optimal supply which is equal to benefits should be the tax imposed. This is called the pigouvian tax. This tax will reduce the supply in market by invreasing the cost of production and thus market supply will reduce and become equal to socially optimal supply and negative externality can be reduced.