Question

Assume that the supply curve is given by p = q and the demand curve of p = 10-q. The production provides
create an externality that is 2 per device. How big tax revenue is the state of one
corporation tax that eliminates externality?

Answer 1

In private market equilibrium, equating demand with supply,

10 - q = q

2q = 10

q = 5

p = q = 5

The externality of 2 units will shifft suply curve leftward by 2 units at every output level so that new supply function is

p - 2 = q

p = 2 + q

Equating with demand,

10 - q = 2 + q

2q = 8

q = 4

p = 10 - 4 = 6

When q = 4, new supply price = 2 + 4 = 6 and original supply price = 4.

The unit tax to eliminate externality is difference between the two supply prices, i.e. (6 - 4) = 2 (= externality cost).

Tax revenue = Unit tax x New quantity = 2 x 4 = 8