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CA Foundation · Business Economics · Public Finance

Producing a unit of steel costs a firm a private marginal cost of Rs 900. Each unit also causes pollution damage worth Rs 150 to nearby residents. The government imposes a per-unit tax equal to the external damage. After the tax, what marginal cost does the firm face per unit, and what does this tax achieve?

The firm faces Rs 1,050 per unit, which is Rs 900 private cost plus the Rs 150 tax. This equals the social marginal cost, so the tax internalises the externality and makes the firm account for the pollution damage in its output decision.

  1. ARs 750; it reduces the firm's cost to the social level
  2. BRs 1,050; it makes private cost equal to social marginal costCorrect
  3. CRs 1,050; it transfers the tax to the residents as compensation
  4. DRs 900; it leaves the firm's decisions unchanged

Explanation

Social marginal cost = private marginal cost 900 + external cost 150 = Rs 1,050. A tax of Rs 150 per unit raises the firm's cost to Rs 1,050, which equals the social marginal cost and internalises the externality. The option that subtracts 150 has the wrong sign, and the tax is not described as compensation.

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