True or false:Suppose a firm imposes an external social cost and the government decides to impose a corrective tax. The tax should be exactly equal to the marginal social cost to ensure that the efficient level of output will be produced.
The correct answer and explanation is:
Correct Answer: False
Explanation (Approx. 300 Words):
The statement claims that a corrective tax (also known as a Pigouvian tax) should be equal to the marginal social cost (MSC) to achieve the efficient level of output. However, this is incorrect.
To achieve efficiency, the corrective tax should be equal to the marginal external cost (MEC)—not the entire marginal social cost. Here’s why:
Understanding the Key Terms:
- Marginal Private Cost (MPC): The cost incurred by the producer for producing one more unit.
- Marginal External Cost (MEC): The cost of that additional unit on society that the producer does not bear (e.g., pollution).
- Marginal Social Cost (MSC): The total cost to society, which is the sum of MPC and MEC.
MSC=MPC+MEC\text{MSC} = \text{MPC} + \text{MEC}
A Pigouvian tax aims to correct a negative externality (like pollution) by internalizing the external cost. When producers are taxed an amount equal to the MEC, their private cost rises to match the MSC. This aligns the producer’s incentives with society’s interest, leading to the socially optimal (efficient) level of output.
Example:
Suppose a factory produces plastic and each ton causes $20 in pollution (MEC), while its private cost is $80. The MSC is $100.
If the government imposes a tax of $100 (equal to MSC), the factory would now face a cost of $180 ($80 MPC + $100 tax), which overcorrects the problem.
The correct tax should be $20, equal to the MEC, raising the firm’s perceived cost to $100 ($80 MPC + $20 tax), which equals the MSC—achieving efficiency.
Conclusion:
The tax should equal the marginal external cost, not the total marginal social cost. Therefore, the statement is false.