Question

The production of paper creates pollution, an external cost. What happens to the production of paper if the government imposes a tax on paper producers equal to the marginal external cost of the pollution?

Answer 1

In the absence of tax, equilibrium output is that where Demand = Marginal Private Cost (MPC). Social optimum is that where Demand = Marginal Social Cost (MSC) and MSC = MPC + Marginal External Cost (MEC). Thus, MSC is upward shift of MPC. So, socially optimum quantity is lesser than equilibrium quantity. However, when tax = MEC is imposed, then MPC + tax is shifted upward so that new equilibrium quantity = socially optimum quantity. Thus, production of paper will be decreased to the social optimum level when tax = marginal external cost is imposed.