Question

Suppose the government wanted to regulate this market using a price-based instrument. What is the efficient level of a tax on emissions?

Answer 1

Tax = Marginal External Damage

Step-by-step explanation:

When a negative externality distorts market outcome, we often see that a government intervention is needed. We must incorporate the negative externality into the private decision of the producer. That is to say that we add marginal damage caused by the externality to the marginal private cost of production. The social outcome will be at the point where marginal social cost (MSC) is equal to Marginal private benefit (MPB).

Thus, the efficient level of tax on emission is set equal to the marginal external damage.

Tax = t = MED

MSC = MPC + MED

= MPC + t