Question

This question refers to a negative externality

(a) Draw and label a diagram to illustrate a negative externality

(b) Using your diagram explain the difference between the market and efficient allocations

(c) Redraw your diagram and use it to explain why a Pigouvian tax can lead to an efficient allocation. What are the problems with a Pigouvian tax?

(d) Draw your diagram a third time and use it to explain Coase Theorem. What are the problems with Coase theorem as a solution to externality problems?

Answer 1

Answer:-

a. The socially efficient quantity is less than the market quantity in case of negative externality.

c. There is welfare loss in the market in case of negative externalities. Therefore, pigouvian tax is imposed.

d. Coase theorem states that if the part being effected is paid the loss it has to incur than it does not matter who is being allotted the property rights. In that case MPC becomes equal to marginal social cost and efficient outcome is attained.