Question

With the help of a diagram, illustrate the deadweight loss associated with a negative externality. How does a Pigouvian tax work to solve the welfare loss from such a deadweight loss?

03 Aug 2023
Answer :
Word Count : 667

A negative externality occurs when the production or consumption of a good imposes costs on third parties who are not involved in the transaction. This can lead to an overallocation of resources towards the production of the good, resulting in a deadweight loss to society. Let's illustrate this concept with a diagram and then explain how a Pigouvian tax can help mitigate the welfare loss.

Diagram:

       Supply
         S
         |
         |        P*      MSC
Price    |         \       |
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