Cambridge International as and a level Economics Ebook

Figure 8.3 
Imposition of an indirect tax
192
Cambridge International A Level Economics

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Th
e government intervenes in this market and imposes 
an indirect tax, which is 
ideally 
equal to the marginal 
external cost. Th
is tax is added to the cost of producing the 
product; the supply curve 
S
2
is now equal to the MPC plus 
this tax. From 
Figure 8.4
, you can see that the price at which 
the product is sold has increased from 
P
1
to 
P
2
. Th
is is less 
than the tax applied by the government. At fi rst sight this 
may appear a little strange, but the producer has accepted 
a cut in the price received from 
P
1
to 
P
3
. Th
e producer has 
borne the burden of part of the tax. Th
e total tax paid is 
equal to the area 
P
2
AB
P
3
, of which the consumer’s share of 
the burden is 
P
2
AC
P
1
and the producer’s share is 
P
1
CB
P
3
. 
Th
e eff ect of the negative externality is now internalised 
within the market. Th
is is an ideal situation; in practice, 
the big problem is being able to know or estimate the exact 
value of the tax that is to be imposed.
Second, governments frequently use 
regulations
to 
overcome market failures caused by production externalities. 
Let us consider the case of a mining company that pollutes 
the surrounding countryside. Th
e government might 
intervene by setting standards that restrict the amount of 
pollution that can be legally dumped. Th
e government would 
then need to regulate and inspect the company to make sure 
that these restrictions are enforced. It can do this in several 
ways, such as by imposing large fi nes on any company that 
contravenes the law. Exhaust fumes from cars pollute the 
atmosphere and, to reduce this problem, the government can 
set legal limits on the amount of carbon particles that are 
emitted from a car’s exhaust pipe.
A third form of intervention is through