Question

Using a supply-demand diagram, demonstrate how pollution taxes (e.g. Pigovian taxes) could be used to improve social outcome. Label your diagrams clear. your explanation must be in your own words to demonstrate your understanding. (About 50 words plus a diagram [which can be hand drawn].)

Answer 1

Without Pigovian tax, supply of goods takes place with consideration of private cost only. It creates E0 equilibrium level where price is P0 and quantity produced is Q0. But, this level of output, creates negative externality. It causes the authority to apply Pigovian tax that shifts the supply curve to the left direction. As a result, the supply taken place when marginal social cost equals the marginal social benefit. At this level, new equilibrium E1 is established that is socially optimal and it is only possible due to Pigovian tax. At this level of equilibrium, quantity is Q1 and price is P1. At this level of outcome, negative externality is eliminated.