What this lesson teaches
I can explain how taxes, subsidies, quotas, tradeable permits, provision, rules and public education correct market failure.
Syllabus 9570, 2.3.3(b). Microeconomic Policies: Policy measures including taxes and subsidies, quotas and tradeable permits, joint and direct provision, rules and regulations, public education in achieving efficiency and equity
Make a guess
A factory's pollution causes $4 of harm for each unit it makes. What tax per unit would lead to the efficient output?
- As high as possible, to stop the pollution.
- Nothing, because taxes only raise prices.
- $4, equal to the external cost.
Show the answer
$4, equal to the external cost.
A tax equal to the marginal external cost makes the firm pay the full social cost, so it produces where MSB = MSC.
A tax equal to the external cost, or a subsidy equal to the external benefit, moves the market to the efficient output.
An indirect tax equal to the marginal external cost makes producers pay the full social cost. MPC + tax becomes MSC, so the market produces Qs. This is called internalising the externality.
A subsidy equal to the marginal external benefit lowers the cost of a good with positive externalities, so output rises to Qs.
Singapore's carbon tax works this way: it was raised to $25 per tonne of emissions in 2024 and rose to $45 per tonne in 2026, the rate set for 2026 and 2027, so that emitters pay more of the cost of their emissions.
The difficulty is measuring the external cost or benefit accurately. A tax that is too low leaves some overproduction; one that is too high cuts output below Qs.
- Tax
- Equal to MEC: internalises the externality.
- Subsidy
- Equal to MEB.
- Problem
- Measuring MEC or MEB.
| Tax | Output | Deadweight loss |
|---|---|---|
| $0 | 80 | $40 |
| $2 | 70 | $10 |
| $4 | 60 | $0 |
| $8 | 40 | $40 |
Worked example: Getting the tax right
In a market with a negative externality, 80 units are produced without a tax, the efficient level is 60, and the external cost is $4 a unit. Each $1 of tax cuts output by 5 units.
- A $4 tax (equal to MEC) cuts output to 60: the efficient level.
- A $2 tax cuts output only to 70, leaving a $10 deadweight loss.
- An $8 tax cuts output to 40, below the efficient level, causing a $40 loss from underproduction.
- A bigger tax is not always better; it must match the external cost.
Watch out for this
The higher the tax on a harmful good, the better.
A tax above the external cost cuts output below the efficient level, which creates a new deadweight loss.
Check your understanding
What size of tax would make a polluting firm produce the efficient output?
- A tax large enough to stop the pollution, whatever happens to output.
- A tax equal to the marginal external cost at the efficient output.
- A tax equal to the firm's profit, so it gains nothing from polluting.
Show the answer
A tax equal to the marginal external cost at the efficient output.
Right. The firm then faces the full social cost.