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The demand curve (D) and supply curve (S) for gasoline in Saskatchewan. The supply curve S is perfectly elastic at a price of \$1.20 per litre, indicating that Saskatchewan residents are able to purchase as much or as little gasoline as they would like at this price. The demand and supply curves intersect to give an equilibrium price of \$1.20 and an equilibrium quantity of 5.00 million litres per day. The own-price elasticity of demand for gasoline is 0.20.The addition of a \$0.06 per litre tax results in the price of gasoline rising to \$1.26. The quantity of gasoline sold can be expected to fall by 0.05 million litres per day; the result is a new equilibrium quantity of 4.95 million barrels per day.
The \$0.06 per litre tax corresponds roughly to a \$25.00 per tonne carbon tax. Assume that the \$25.00 per tonne figure represents the “externality” or external cost that a carbon user imposes on others as a result of using an additional tonne of carbon.

1. Why does carbon use create an externality
2. Explain why the \$25.00 per tonne can be considered as the optimal tax (Hint: See Assignment 2).
3. Using the values on the graph in Figure 1, fill in the entries in Table 1 (i.e., calculate the numerical values and indicate the graphical areas). Please note the external costs should be entered as a negative.
4. What is the deadweight loss in this case (numerical value and graphical area) Explain why this is a deadweight loss
5. Using Figure 1, fill in the entries in Table 2 under the assumption that the external cost is zero.
6. What is the deadweight loss in this case (numerical value and graphical area) Explain why this is a deadweight loss
7. Explain why the introduction of a tax in the first case leads to an increase in economic welfare, while in the second case the introduction of a tax leads to a decrease in economic welfare.
8. Tables 1 and 2 show the results of what is effectively a cost-benefit analysis. Assuming carbon usage creates an externality, what policy option (tax or no tax) would you recommend based on the cost-benefit analysis Why
9. Assuming that carbon usage does not create an externality, what policy option (tax or no tax) would you recommend based on the cost-benefit analysis Why In this question and the previous one, is it necessary to consider anything else besides what is shown in the table
10. Who is experiencing the external cost in the case of carbon usage (and greenhouse gas emissions)
11. As we discussed in class, while the tax revenue that is collected in the externality case is equal to the external cost that is being experienced, the tax revenue that is collected does not necessarily go to those that are experiencing the external cost. What political problems does this create.

## Why does carbon use create an externality

Externality in economics refers to the external effect of an economic activity that are not taken into consideration by the direct agents involved in the market transaction. Producers do not consider the external cost associated with the production. The carbon use has an external cost in the form of harming environment (Baumol & Blinder 2015). The gasoline producers however do not consider the cost of environment degradation while taking marketing decision. The market price thus fails to reflect the additional cost generated from carbon use and hence, it creates an externality.

In the presence of external cost, the private marginal cost of production is lower than the social marginal cost. The optimal social outcome is obtained from the intersection of marginal social cost and marginal social benefit. The market equilibrium under the presence of externality is determined from the intersection of private marginal cost and marginal benefit. As external cost is not taken into consideration, the market output is higher than social optimum.

In order to attain socially optimum output, the private marginal cost should coincide with social marginal cost. The difference between private and social marginal cost equals the external cost of production (Nguyen & Wait, 2018). A tax equivalent to the external cost thus is optimal. The imposed tax shifts the supply curve upward to coincide with marginal social cost and hence, socially efficient outcome is attained after imposition of tax equivalent to external cost. Using figure 1, the inverse demand function is obtained as

In a market with external cost of carbon usages the economic surpluses can be computed as

Table1: Economic Welfare Impact of a Carbon Tax on Speci?c Groups, Social Cost of Carbon Usage
With social cost
Case
Before tax    After tax    Change     Area
Producer Surplus    -0.015    0    0.015    bcf
Consumer surplus    150    147.015    -2.985    abcd
External Cost    -25    0    25
Tax Revenue    0    2.97         abed
Total Economic Surplus    149.985    150    0.015    bcf

With social external cost, deadweight loss presents if the market is left unregulated. With externality, the free market outcome in the market is 50 barrels of oil per day. The socially efficient outcome is lower and is 49.5 barrels per day. As free market produces lower than socially efficient outcome, resources are not optimally used under free market. The deadweight loss is generated due to loss in welfare following lower than optimal market outcome (Nicholson & Snyder, 2014) The tax however corrects the externality and internalize the external cost. With tax as socially efficient outcome is attained, there is maximum social welfare with zero social welfare.

Table2: Economic Welfare Impact of a Carbon Tax on Speci?c Groups, No Social Cost of Carbon Usage
No Social cost
Case
Before tax    After tax    Change     Area
Producer Surplus    0    0    0
Consumer surplus    150    147.015    -2.985    abcd
External Cost    0    0    0
Tax Revenue    0    2.97    0    abed
Total Economic Surplus    150    149.985    -0.015    bec

## Explanation of the optimal tax level

If external cost is zero, the free market can attain the socially efficient outcome. The intervention of government through imposition of distorts the allocation of resources resulting in a welfare loss or deadweight loss. With tax, price paid by the consumer increases by the amount the tax. Because of perfectly elastic supply curve, the entire burden of tax is borne by the buyers. The higher price lower the surplus to the consumer by the area abcd. Part of the lost consumer surplus goes to the government as tax revenue (Beeks & Lambert, 2018) The rest neither goes to producers nor goes to government. The area bec thus is a net loss in social welfare due to taxation and is called deadweight loss.

In the first case, tax is used as a tool to correct externality. Because of external cost generated from carbon usage, the unregulated market fails to ensure socially efficient outcome. The imposition of tax corrects the negative externality and ensure socially optimum outcome. As introduction of tax in this case moves the market towards socially efficient outcome, tax leads to an increase in social welfare.
In the second case, however social cost is zero. Here, free market alone attain the socially efficient outcome. The introduction of tax imposes additional burden on buyers in the form of higher price. Under free market scenario, imposition of tax distorts the market outcome. The social inefficiency can be observed from the deadweight loss from the imposition of tax (Kolmar, 2017). Because of the resulted deadweight loss, there is a decrease in social welfare after tax.

The cost benefit analysis comprises analysis of associated cost and benefit of a policy action. In case where carbon usage creates an externality, the supply curve shifts upward exactly by the amount of external cost. The new supply curve after the tax is the actual social marginal cost. After the tax, output lowers to 49.5 barrels per day while price increases to \$1.26. The consumer surplus lowers by the area given by abcd. The outcome is socially optimal (Cowen & Tabarrok, 2015) As tax on carbon completely internalize the externality, the recommended policy is to impose a tax equivalent to the external cost.

If carbon usage does not create an externality, then the recommended policy option is no tax. As revealed from the cost benefit analysis under zero social cost, economic welfare decrease after tax resulting in a net welfare loss given by the area bcf. The suitable policy option thus is to leave the market unregulated (Meiners, 2017)

In case of carbon usage, the external cost is created in forms of environmental pollution. The entire society experiences the external cost.

In order to completely internalize the external cost government should spend the tax revenue to increase welfare of those experiencing externality. A political transparency however is needed to allocate the collected revenue for well-being of the society. With corruption among the government officials, the entire revenue does not spend on social welfare. This might create resentments among the tax payers questioning the political system (Beeks & Lambert, 2018) Therefore, transparency in the political system is required to correct the external cost and maximizing social welfare.

References

Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Nelson Education.Beeks, J. C., & Lambert, T. (2018). Addressing Externalities: An Externality Factor Tax-Subsidy Proposal. European Journal of Sustainable Development Research, 2(2), 19.

Cowen, T., & Tabarrok, A. (2015). Modern principles of microeconomics. Macmillan International Higher Education. Kolmar, M. (2017). Externalities and the Limits of Markets. In Principles of Microeconomics (pp. 99-141). Springer,Cham.

Meiners, R. E. (2017). Bad Economics, Good Law: The Concept of Externality. In Explorations in Public Sector Economics (pp. 61-91). Springer, Cham.

Nguyen, B., & Wait, A. (2015). Essentials of Microeconomics. Routledge.Nicholson, W., & Snyder, C. (2014). Intermediate microeconomics and its application. Nelson Education.

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