Question

1. The factory of Hair-Puffs Inc. produces hair-wigs.  As a by-product of this wig production, it also produces dangerous emissions of toxic gases(as a result of the strong glue used to hold the hair in place).  The De-Lite car factory, down the road, experiences a negative externality from this production process.
Suppose that the supply curve (private marginal cost) for the wig factory is of normal upward slope, and it faces a market demand or marginal benefit curve, also of normal slope.  The marginal damages caused by the production of wigs slopes upward as you can imagine.  Using the typical supply and demand diagram: d. Show the area of a Pigouvian Tax were the government to use this tax to create a socially efficient level of production.

2. Why is it not necessary to compensate either Hair-Puffs or De-Lite for welfare losses using the receipts of the Pigouvian Tax?

Answer 1

demand curve is downward sloping . The marginal damage and supply curve ( based mon private marginal cost) is upward sloping . Given. the demand and supply curve , equilibrium point is E where OY1 level of output is produced. However due to the presence of negative externality this is not socially efficient level of output .The socially efficient level of output is based on the supply curve S'S' ( which is marginal private cost + marginal damage ) . Socially efficient level of output is given by point F where the output level is OY2.

FG   the per unit tax is the amount of pigouvian tax that the government should impose to create socially efficient level of production.

marginal damage at OY1 to de lite = FGEH

loss of welfare to hair puff when OY2 produced = FEG

when output reduced to OY2 , reduction in damage > loss to hair puff , so overall welfare has improved because of taxes .

so there is no need of compensation .