Scenario: The production of a good creates a negative externality. The following figure shows the market for this good.

-Refer to the scenario above.To restore the socially optimal outcome in this market,the government should ________.
A) levy a $6 tax per unit on this good
B) levy a $10 tax per unit on this good
C) pay a $6 subsidy per unit on this good
D) not intervene in the market, as the market will provide the socially optimal outcome by itself

Question

Scenario: The production of a good creates a negative externality. The following figure shows the market for this good.
 
-Refer to the scenario above.To restore the socially optimal outcome in this market,the government should ________.
A) levy a $6 tax per unit on this good 
B) levy a $10 tax per unit on this good 
C) pay a $6 subsidy per unit on this good 
D) not intervene in the market, as the market will provide the socially optimal outcome by itself

Quizplus · Accepted Answer

The socially optimal outcome occurs where the marginal social cost (MSC) intersects with the demand curve. In this case, the equilibrium occurs at point E, where the marginal private cost (MPC) intersects with the demand curve. As production of the good creates a negative externality, the MSC lies above the MPC curve. To restore the socially optimal outcome, the government can levy a tax on the production of the good equal to the vertical distance between the MPC and MSC curves at the point where the demand curve intersects with the MPC curve. This amount is equal to $10 per unit, so choice B is the correct answer.

Scenario: the Production of a Good Creates a Negative Externality