Question

How can a corrective tax adjust costs to reflect externalities? What effects will a corrective tax have on prices, output, and pollution?

Answer 1

In economics, an activity is considered an externality when its production and consumption affects a third party that is not related to this activity. Sometimes, externality are not visible in price mechanism. This creates inefficiency. There are mainly 2 types of externalities and their examples are
1. Positive: Knowledge does not only benefit the person who acquired it, but its benefits expands to others as well.
2 Negative: Pollution created by industries for example affects the environment.

Several methods have been suggested to correct the negative externality and internalize it under price mechanism.
One of which is Corrective taxation which regulates the marginal private cost in order to internalise the externality. It generally equals marginal external cost per unit of output. The negative externality gets reflected in prices as the producer is levied a tax equal to marginal external cost. (Tax=MEC)

Effect of corrective Tax on prices: The tax levied gets reflected in the prices as cost of production increases. The producer shifts the burden of tax onto the consumer. Increase in0 price of the product and consumers are discouraged.

Effect of corrective tax on output: The tax levied on per unit of output creates a left shift on the supply such that it shifts the output to optimum level.

Effect of corrective tax on pollution: The corrective tax does not work in objective to reduce polllution to zero. What it does is to internalise the marginal social cost incurred and makes producers and consumers aware of the damages due to the activity.