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Pigouvian taxes for efficient market outcomes

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Suppose that the (inverse) market demand curve for a certain drug is given by: p=100-q and the market supply curve is given by p=q. Suppose also that the drug is created from a bodily fluid extracted from an endangered species. Extracting the fluid kills the animal. Since society places some value on the existence of the animal, the production of the drug incurs additional societal costs beyond those which are already reflected in the market supply curve. Specifically, suppose that the marginal cost to society (beyond the direct production cost of the drug) is equal to 2q.

A) What is the quantity of drugs that is produced by the market?
B) What is the socially efficient quantity of drugs that should be produced?
C) What size of Pigouvian tax should result in the efficient quantity of drugs being produced?

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Solution Summary

Free market outcome compared with Pigouvian tax outcome. Market efficiency and marginal costs to society.

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Negative externalities are costs that are not borne by the parties to the economic transaction. A producer may, for example, pollute the environment, and others may bear those costs. An individual may be a smoker or alcoholic and impose costs on others. In these cases, production or consumption of the good in question may differ from the optimum level.

In this case, the producer does not bear the cost of the extinction of the animal. This negative externality causes the equilibrium output will be more than the efficient output. This is because ...

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