Question

(c) Draw a diagram to illustrate the case of perfect competition where there is a negative production externality. Show how, if the production externality is ignored, output will differ compared to the alternative where society’s needs are taken into account. Explain briefly how a tax could be relevant in achieving the social optimum (a) Sketch the Average Fixed Cost curve for a firm, and explain why it is the shape you have shown it. (b) Explain why it might be rational for a profit-maximising railway operator to offer lower prices to students than to other passengers. In particular, how might your answer to part (a) be relevant here? (d) How should the operator set its prices in this case?

Answer 1

c)Under negative externalities, the MSC which incorporates the cost to 3^rd party, is not equivalent to the supply curve for the product, which incorporates only the private expenses of production to firms of the product. Thus, MSC exceeds the supply curve. A corrective taxation is proposed to adjust the marginal private cost of a product in such a manner so as to internalize the negative externality. The taxation must be equivalent to the marginal external cost / unit of output in order to obtain this aim. In effect, a corrective taxation is like a charge for waste emission. It is proposed to internalize an externality by making firms of the good pay a fee equivalent to the MEC /unit of product sold.