Question

Since both taxes and subsidies create a deadweight loss to society, why are they used to correct negative and positive externalities? Ensure to explain whether society is better off or worse off and why.

Answer 1

Taxes and subsidies create deadweight loss when used in isolation, but in the context of externalities, taxes and subsidies are used to correct the market. If not done, then it will create a market failure that hurts more to the economy. With the help of taxes, negative externality is corrected and subsidies are used to correct positive externality so that socially optimal equilibrium is achieved where, MSC = MSB.

Hence, taxes are used to curtail the profit making drive of the firms and its negative impact upon environment and others. In contrast to it, subsidies are used to spread the positive impact upon the society, that is brought by the positive externality.

In both the correction of negative and positive externality, society gets better off and it can be understood by examples. Correcting negative externality due to pollution by applying taxes, help people get cleaner and greener environment. A positive externality spread by universities, is further spread by offering subsidies to these universities so that fees are lowered and more people get education.