The graph below shows the marginal social cost, supply, and marginal social benefit in an industry that generates pollution. Use this graph to answer Questions 53 and 54.

Suppose the industry is currently producing the quantity Q2 and the price is $100. If a Pigouvian tax equal to the marginal external cost is imposed, what will happen to society’s total surplus and the deadweight loss in the industry?

Total surplus

Deadweight loss

A.

decrease

stay the same

B.

increase

decrease

C.

increase

increase

D.

decrease

decrease

E.

increase

stay the same

Question

The graph below shows the marginal social cost, supply, and marginal social benefit in an industry that generates pollution. Use this graph to answer Questions 53 and 54.

Suppose the industry is currently producing the quantity Q2 and the price is $100. If a Pigouvian tax equal to the marginal external cost is imposed, what will happen to society’s total surplus and the deadweight loss in the industry?

Total surplus

Deadweight loss

A.

decrease

stay the same

B.

increase

decrease

C.

increase

D.

decrease

E.

increase

stay the same

BlackTom AI · Accepted Answer

A Pigouvian tax equal to the marginal external cost makes private marginal cost plus the tax equal to the marginal social cost (MSC), so firms face the true social cost of production.

Relevant knowledge points:
- Negative externalities (pollution) cause private marginal cost (supply) to be lower than MSC, so the unregulated market overproduces relative to the social optimum.
- The socially optimal quantity is where marginal social benefit (MSB) = MSC.
- Deadweight loss (DWL) from an externality is the triangular loss in net social surplus created by producing the overproduced units (area between MSB and MSC from the social optimum to the market quantity).
- A correctly sized Pigouvian tax internalizes the externality by shifting the supply curve upward by the marginal external cost, moving output to the social optimum and reducing DWL.

Step-by-step reasoning:
1. Identify the starting situation: the industry is producing Q2 at price $100 based on private supply (S) and MSB. Because MSC lies above S (the graph shows MSC to the left intersection with MSB at a lower quantity Q1), the market quantity Q2 exceeds the socially efficient quantity Q1 — so there is overproduction and a DWL equal to the triangle between MSB and MSC for quantities Q1 to Q2.
2. Impose a Pigouvian tax equal to the marginal external cost. This raises firms’ private marginal cost by exactly the external cost, shifting the supply curve up to coincide with MSC.
3. The new equilibrium occurs where MSB = MSC, i.e., at Q1, the socially efficient quantity. Output falls from Q2 to Q1.
4. The previous DWL (area between MSB and MSC from Q1 to Q2) is eliminated or reduced because production now equals the social optimum. Total social surplus (sum of consumer and producer surplus minus external costs) increases because the prior loss due to unpriced externality is removed.

Why the correct answer (B) is correct:
- Total surplus increases because internalizing the externality eliminates the inefficiency and recovers the net welfare represented by the previously lost triangle.
- Deadweight loss decreases (in the ideal case to zero) because output is reduced from the inefficient Q2 to the efficient Q1.

Why the other choices are incorrect:
- A and D (total surplus decreases) are wrong because properly pricing the externality raises net social welfare rather than lowering it.
- C (DWL increases) is wrong because aligning private costs with social costs reduces, not increases, inefficiency.
- E (DWL stays the same) is wrong because the tax changes quantity to the social optimum and thus changes (reduces) the DWL.

Conclusion: Imposing the Pigouvian tax increases society’s total surplus and decreases deadweight loss, matching answer B.

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