Question

In order to address climate change, the government of a large industrialized economy has decided to implement carbon taxes directly onto producers. Now a provider of a product or service must pay per unit tax on every unit it sells. The amount of the tax is based entirely on the cost of the environmental impact that unit will have. If the economic activity has a positive impact on the environment, the producer will get a subsidy based on the environment benefit that product creates. The majority of output in the economy will be assessed as having some kind of negative environmental impact.

1. What is the economic phenomenon that the government is trying to address here?
2. Assuming the economy was in long-run equilibrium at the time the tax was implemented, please describe the short run impact on the AD and AS curves and on prices and economic output in the economy.
3. Do you think there will be an impact on the LAS?

Answer 1

a) the economic phenomenon that government is trying to address is externality .In presence of externality , there is misallocation of resources . Incase of negative externality , output produced > socially optimum level of output , where in case of positive externality ,output produced < socially efficient output level .

b) If the economy is initially in equilibrium , then AD and AS curve intersect at point E in the digram such that output = OY1 and price= OP1 . As a result of tax , firms will reduce their output to the socially efficient level .AS curve will shift left from AS to AS' as majority of output has negative externality so aggregate supply will fall . This will cause the prices to rise from Op1 to OP2 and output will fall from OY1 to OY2.

c) Yes , it will have an impact on long run aggregate supply.