. The production of plastic creates pollution, which, in sufficient quantities,

Question

. The production of plastic creates pollution, which, in sufficient quantities, can harm people’s health. Assume that the plastic industry is perfectly competitive. We know that the industry will produce more output than is socially optimal, since firms do not bear the costs of pollution (that is, pollution is a negative externality). Without government intervention, the market output will be 50 million units at a price of $10, where $10 is the minimum AC of firms in the industry. The marginal social cost of plastic is $15 at this level of output. Since marginal cost exceeds price, output is too high. The socially optimal output is 30 million units at a price of $13. This output can be attained by levying an excise tax of $3 on each unit of plastic. Assume that the demand and marginal social cost (MSC) curves are linear, as shown in the graph below.

(a) Calculate the loss of consumer surplus associated with the $3 tax. This is the loss that buyers of plastic incur when we move to the socially optimal output level.

(b) Calculate the reduction in pollution costs that occurs because of the tax.

(c) Calculate the government revenues from the tax.

(d) Using your answers to 1-3, show that the gains exceed the losses from the tax.

(e) The government generally cannot determine the correct tax to levy, since it does not know the demand and marginal social cost curves. Suppose the government levies a $5 tax, which is the marginal cost of pollution at the level of output that occurs without government intervention (that is, at 50 million units). Do the gains from this $5 tax exceed the losses, or vice versa? You can answer this by just looking at the graph, without any calculation—just answer and explain.

Explanation / Answer

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