Question

A coal-fired power plant produces power  with costs . Each unit of power earns the plant . Burning coal releases particulate matter (PM2.5), a pollutant that is known to cause heart disease, lung disease, and birth defects. The coal plant borders a wildlife sanctuary which sells tourism visits  for a price $30. However, the sanctuary's animals are getting sick due to the negative externality of PM2.5, such that the costs to the sanctuary are . The local government decides to tax the coal plant to internalize its negative externality. What tax will restore the social optimum?

Answer 1

Negative externalities are the costs incurred by a third party as a consequence to some activity in which the affected party may or may not be involved. In this case, we see that, due to the emission of coal matter (PM2.5) there are a lot of adverse hazards that happen as a consequence. Due to the pollutant, people suffer with heart diseases, lung irritations ,asphyxiation, birth defects and other complications in human beings, animals in the sanctuary and the surrounding environment.

In efforts to reduce such implications and the high volumes of PM2.5 being released in the air, a Pigovian Tax needs to be imposed on the coal power plant as compensation for all damages and hazards caused. A Pigovian tax is a type of tax that is imposed on any entity or market for the negative externalities caused as a consequence or bi-product of an economic activity. Pigovian Tax is equal to the social cost of the negative externalities caused by an economic activity.

In order to control over production and to reduce the negative externalities caused , governments can analyze and estimate the social cost incurred by the negative externalities and could impose this cost as tax on the producer, thereby increasing marginal cost of the firm. As the producer now has to pay extra taxes for producing more, this will efficiently reduce the quantity of units produced by the firm, enabling reduced negative externalities caused and preventing over-production, thus establishing a balance a economy, society and the environment. Therefore a Pigovian Tax helps in restoring social optimum.