Pollution as a part of externalities

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Pollution is a problem for every economy. The main reason pollution exists is because no natural or human process is one hundred percent efficient. This paper takes a holistic look at pollution as a part of externalities. The paper argues for the for the imposition of tax on external costs such as pollution and allotment of subsidies on external benefits such as healthcare to compensate for cost and benefits respectfully, of production or consumption experienced by society. The argument for tax and subsidy takes into consideration the two extremes of the market; perfect competition and monopolistic competition. The paper seeks to show how the introduction pollution tax brings a market closer to the point where firms produce the maximum output at the least cost in order to avoid market failure.

Market Failure

A market is said to have failed when there is either over-production or under-production by the typical firms in the market. When there is over production or under production in a market, there is the creation of externalities. A firm is said to be over producing when the Marginal Social Cost (MSC) is greater than the Marginal Cost (MC). This creates an external cost such as pollution. As shown in Graph 1a. Under- production on the other hand exists when MSC is less than MC. This creates an external benefit such as the provision of healthcare, as shown in Graph 1b. The Marginal Social Cost (MSC) is the private social cost plus any externalities borne by everyone else outside the market. Marginal Cost (MC) is the cost of the next unit of production.

A Case for Taxation

To correct market failure, a market must strive to be efficient. One way of correcting market failure is the control of common resources. In most economies, common resources are owned by the government. A government can set control to curb over and under production by introducing tax and subsidy respectively. The imposition of tax on pollution as a way of correcting market failure and achieving market efficiency is done by governments. The taxation of pollution in over production and subsidy in under pollution will be discussed in both Perfect competition and Monopolistic competition.

Taxation in Perfect Competition

As shown in graph 1a, there is evidence of external cost (pollution) in the production process. The introduction of tax will compensate the society outside the market and correct the problem of market efficiency. In graph 2a, the firm is maximizing profits at Q1, where the MC curve meets Price (p). At this point the firm does not take cognizance of the external costs it creates for society. The difference between MSC and MC will be the amount of tax levied on the firm. This will internalize the cost of the externality and make the firm produce at MSC where the marginal social cost equals the marginal social benefit. At this point, the firm is forced to maximize profits at Q2, where the MSC curve meets price.

On the other hand when MSC is less than MC as shown in the graph 2b, there is under production causing an external benefit to the society which is not being met by the producer. Unlike taxation, government subsidizes at MC to meet MSC. Government bears part of the cost in driving supply closer to MC through subsidy. The subsidy is the size of the difference between MC and MSC. As with the example of healthcare, healthcare (external benefit) is provided at Q1, on graph 2b. Subsidy is given on every extra health provision made by the healthcare provider as an incentive to drive MC to MSC which is where healthcare is socially optimum.

Taxation on Monopoly

Monopoly licenses are granted for many reasons. One of which is to have control on the monopoly firm. Most monopoly firms produce an essential good or service, hence the importance of the firm to the society. For a company that has monopoly power and produces externalities, the dynamics of correcting market failure through taxation of its pollution is different. Graph 3a, best explains the dynamics of pollution tax on a monopoly. The firm is making profit at Q1, where MC crosses the Marginal Revenue (MR) line, yet MSC crosses the MR line at Q2. The difference between Q1 and Q2 is the external cost to society (pollution). Unlike the Perfect Competition, where the tax imposed is the difference between MSC and MC and is internalized by the firm, the monopoly firm does not bear the full cost of externalities. The cost of externalities is borne by the firm and the society at Q3. This is because if the firm internalizes the whole external cost, it will be maximizing profits at P2. Even though this is the point where the MSC curve meets the MR line, it will be too expensive for consumers. Thus the burden of tax is split within MSC and MC at Q3. Though it is not the same as MSC it brings the society close to MSC.

Another way of government taxing monopolies is by imposing a lump-sum tax on production. This is a way of controlling the profits that the monopolies make. With a lump sum tax, proceeds can be used for specific developmental projects. In effect, the imposition of tax helps in making the economy socially efficient.

In conclusion, every economist will strive to achieve an efficient market, as the benefits are immense. The case for taxation is stated in the paragraphs above to achieve an efficient market but this can only be realized in the first best world where we assume ceteris paribus. In the second best world, taxation brings the society close to socially optimum point. In spite of the difficulty in achieving Pareto Optimality, taxation promotes productive efficiency as stated in the essay above.


Taxation is a way of promoting market efficiency as argued in the essay above. When the whole economy is taxed, there is a sense of cheating as the rich in society get to pay the same amount of tax as the poor in society. Economists have found it prudent to impose higher taxes on certain goods like alcohol which are termed demerit goods. The perception on the consumption of these goods is that it consumed by the well off in the society. This essay will look at the gravity of deadweight loss from tax on alcohol in the long and short run spanning five years.

Deadweight Loss

The deadweight loss can be described as the aggregate loss in the degree of consumer and producer surpluses due to the imposition of tax on a product. The deadweight on alcohol is illustrated in the graph 3a in the appendix. Before the imposition of tax, equilibrium is set at Q1 fr quantity demanded and P1 for price. When tax is set, a new supply curve is created by adding tax to supply. This causes the price of alcohol to increase to P2 and quantity reduced to Q2. Due to the existence of tax, the supplier now has after-tax revenue of P2-tax. The consumer surplus which stood at portions of the graph labeled X, Y and Z before the tax has dropped to only X. consequently, producer surplus which stood at A, B and C before the tax will drop to the area labeled b after tax. Consumers and suppliers end up giving up areas labeled Y and A respectively in the form of tax to government. This same area is what is known as the deadweight loss from taxing alcohol.

The effects of Deadweight loss in Year One

In the first year of the imposition of tax on alcohol, price will go up but demand will not drop significantly. This is because reaction to the imposition of tax by consumers and suppliers alike is inelastic in the short run. This means that when tax is introduced, demand drops insignificantly despite the hike in the price of alcohol as shown in the graph 4a in the appendix. That means that revenue increases, thus more revenue for government from the tax on alcohol. The hike in price also shows that there will be great deadweight loss. In the same year suppliers can only increase production minimally as shown in graph 4b. Producers can entice workers to do overtime shifts but do not have enough time to alter their factors of production. The effect of deadweight loss on tax in the short run is very great.

The effects of Deadweight loss in Year Five

In the fifth year after the imposition of tax, reaction to alcohol prices will change by both suppliers and consumers. Supply and demand both become elastic. Demand becomes elastic over time because, consumers feel the effect of the hike in price caused by tax and react to it accordingly. This is shown by a drastic reduction in quantity demanded in the graph labeled 5a. This can be as a result of people feeling the effects of the tax thus looking for alternatives or quitting alcohol. The supply of alcohol also becomes elastic in the fifth year as shown in graph 5b. In the fifth year, suppliers have enough time to alter their factors of production to meet the demands of the first year. In the fifth year, since demand for alcohol has decreased, there will be a decreased deadweight loss to both suppliers and consumers compared to the first year.

In conclusion, the deadweight loss from the imposition of tax on alcohol is significantly greater in the short run than it is in the long run. It is argued in the essay that S