Question

Explain how corrective taxes and subsidies can be used to internalize and externality.

Answer 1

When there is a negative externality, social marginal cost (SMC) is higher than private marginal cost (PMC) by the amount of marginal external cost (MEC), such that SMC = PMC + MEC, and SMC curve lies to the left of PMC curve. While market equilibrium is obtained at intersection of private marginal benefit (PMB) and PMC curves, socially optimal outcome is at intersection of PMB and SMC curves, therefore socially optimal price is higher and quantity is lower than private market outcome, unless the externality is internalized. If a Pigouvian tax equal to (SMC - PMC) be imposed at the socially outcome output level, the negative externality can be internalized.

Similarly, When there is a positive externality, social marginal benefit (SMB) is higher than private marginal benefit (PMM) by the amount of marginal external benefit (MEB), such that SMB = PMB + MEB, and SMB curve lies to the right of PMB curve. While market equilibrium is obtained at intersection of private marginal benefit (PMB) and PMC curves, socially optimal outcome is at intersection of SMB and PMC curves, therefore socially optimal price is lower and quantity is higher than private market outcome, unless the externality is internalized. If a Pigouvian subsidy equal to (SMB - PMB) be imposed at the socially outcome output level, the positive externality can be internalized.