Refer to the competitive market diagram for product Z. Assume that the current market demand and supply curves for Z are D2 and S2. If there are substantial external costs associated with the
Production of Z, then
A) a price lower than B and an output greater than G would improve resource allocation.
B) government should levy a per-unit excise tax on Z to shift the demand curve to the right.
C) government should levy a per-unit excise tax on Z to shift the supply curve toward S1.
D) government should subsidize the production of Z to lower equilibrium price and increase equilibrium output.

Question

Refer to the competitive market diagram for product Z. Assume that the current market demand and supply curves for Z are D2 and S2. If there are substantial external costs associated with the
Production of Z, then
A) a price lower than B and an output greater than G would improve resource allocation. 
B) government should levy a per-unit excise tax on Z to shift the demand curve to the right. 
C) government should levy a per-unit excise tax on Z to shift the supply curve toward S1. 
D) government should subsidize the production of Z to lower equilibrium price and increase equilibrium output.

Quizplus · Accepted Answer

If there are substantial external costs associated with the production of Z, then there is a market failure since the market equilibrium does not take into account these costs. To correct for this market failure, the government should intervene by imposing a per-unit excise tax on Z, which would shift the supply curve toward S1. This would increase the price of Z, reduce its quantity demanded, and induce firms to reduce production or find alternatives that are less damaging to the environment. By shifting the supply curve, the tax would internalize the external costs and align private and social costs, resulting in a more efficient allocation of resources. A and D are incorrect since they do not address the external costs and may worsen the market failure. B is incorrect since it suggests shifting the demand curve, which would only increase the quantity demanded and exacerbate the problem.

Refer to the Competitive Market Diagram for Product Z