Indirect Tax and Market failure

Question 1

How does an indirect tax correct a negative production externality?

Answer 1

Firms produce at a quantity where MPC = MPB, ignoring external costs.

A negative production externality means MSC > MPC, leading to overproduction.

An indirect tax raises the firm’s costs of production, shifting the MPC curve leftward.

Ideally, MPC + Tax = MSC, leading to production at the social optimum (Q)* and price P*.

This internalizes the externality, reducing welfare loss.

Question 2

Diagram summary 1:

Answer 2

MPC shifts left to meet MSC

Overproduction reduced from Q₁ to Q*

Welfare loss triangle eliminated

Question 3

How does an indirect tax correct a negative consumption externality?

Answer 3

Consumers consume where MPB = MPC, ignoring external costs (like second-hand smoke, alcohol harm).

A negative consumption externality means MSB < MPB.

An indirect tax raises the private cost (MPC) to the level of MSC.

This reduces consumption to the socially optimal level Q* and increases price to P₂.

Question 4

Diagram summary 2:

Answer 4

MPC shifts left (upward) due to tax

Consumption drops from Q₁ to Q*

Price rises from P* to P₂

Welfare loss reduced

Question 5

What are the advantages of using indirect taxes to correct negative externalities?

Answer 5

Internalizes the externality: Tax forces producers/consumers to account for external costs, aligning MPC with MSC or MPB with MSB.

Corrects overconsumption/overproduction: Market moves to the social optimum (Q)*, reducing welfare loss.

Government revenue generated:

Shown by the vertical distance between supply curves × new quantity sold.

Can be ring-fenced to fund solutions (e.g. education, healthcare, subsidies for alternatives).

Polluter pays principle: Shifts cost burden to those causing the harm (e.g. carbon tax).

Question 6

What are the drawbacks of using indirect taxes to correct negative externalities?

Answer 6

Inelastic demand:

Goods like alcohol, tobacco, and sugar have addictive or habitual consumption.

Even after a tax, quantity demanded falls very little, so externality persists.

Difficult to set the ‘right’ tax level:

Assumes perfect information about the size of the externality (MSC).

Likely to over-tax (causing black markets) or under-tax (externality not corrected).

Regressive impact:

Indirect taxes can disproportionately affect low-income households, worsening inequality.

Unintended consequences:

Black markets, smuggling, or firm relocation to avoid tax.

Question 7

What are the key drawbacks of using indirect taxes to correct negative externalities?

Answer 7

Inelastic Demand

For goods like cigarettes, alcohol, and sugary drinks, demand is price inelastic due to addiction or habit.

Even with higher prices, consumption may not fall enough to correct the market failure.

Difficult to Set the Correct Tax Level

Governments rarely have perfect information on the external costs.

If tax is too low, the externality isn’t fully internalized.

If tax is too high, it may create inefficiencies or black markets.

Regressive Impact

Indirect taxes take a larger proportion of income from the poor than from the rich.

This worsens income inequality, contradicting the government’s macroeconomic goal of fairer income distribution.

Black Markets

Excessively high prices due to taxation can encourage illegal trade.

Examples:

Cigarette black market valued at £2 billion/year (2018, UK)

Alcohol smuggling worth £1.3 billion/year (2018, UK)

These undermine the tax’s effectiveness and reduce government revenue.