Question

Explain how excise taxes and production subsidies can move a market with externalities to a more efficient outcome.

Answer 1

Externalities are the benefits or costs incurred by a third person because of the production or consumption activity by any other person. There are two types of externalities:

1. Negative externality is the cost incurred by any third party because of production or consumption activity of a person. In this case the Marginal Private Cost to the person is less than the Marginal Social Cost and hence there is over production/consumption. So in order to bring the supply to the social optimum level an excise tax is imposed and hence private cost increases bringing the supply to the socially optimum level.

2. Positive externality is the benefit to the society from the production or consumption of a good or service. In this case social benefit is higjer than private benefit or social cost is less than private cost. So there is shortage in the market. So in order to increase supply government provides subsidy whicj brings down private cost increasing supply to reach social optimum.

These processes are graphically shown as