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IAI Actuarial Core Principles · Business Economics · Relationship between the government and the individual firm

A factory in Gujarat emits pollutants whose cost to nearby residents is not borne by the firm. The government imposes a tax per unit of output equal to the marginal external cost at the socially optimal output. Which statement best describes the effect of this tax?

The tax internalises the negative externality: by adding the marginal external cost to the firm's private marginal cost, the firm's private cost equals marginal social cost, so it reduces output to the socially efficient level.

  1. AIt internalises the externality by raising the firm's private marginal cost to equal marginal social costCorrect
  2. BIt eliminates the firm's fixed costs
  3. CIt shifts the demand curve to the right
  4. DIt converts the good into a public good
  5. It raises the marginal social benefit of the good

Explanation

A Pigouvian tax equal to marginal external cost adds that cost to the firm's private marginal cost, so private marginal cost equals marginal social cost and output moves to the social optimum. It does not affect fixed costs or demand directly.

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