Imposing a tax on the suppliers is one policy the government might pursue. If the government taxes the firms, the supply of the product decreases and the supply curve shifts leftward. Moreover, if the tax equals the cost of the marginal externality, then the supply curve shifts leftward until it is the same as the marginal social cost curve.

The figure shows the effect of this policy. Imposing a tax equal to the cost of the marginal externality shifts, by rotating, the initial supply curve, S, until the supply curve with the tax, S + tax, becomes the same as the MSC line. As the shifting occurs, the deadweight loss (the grey area) becomes smaller until at the end, when the shift is completed, the deadweight loss disappears. Imposing the tax so that the supply curve and marginal social cost curve become the same line, means that the amount the market produces, Q_E, is the same as the allocatively efficient quantity, Q_AE. Moreover, as the figure shows, when the tax is imposed so that the supply and marginal social cost curves are identical, the coloured area showing the amount of surplus is at its maximum. In other words, the appropriate tax has eliminated the deadweight loss and thereby increased society's total surplus to its maximum. Society is better off with the tax!

The intuition behind the result that a tax can improve society's well-being may help clarify this conclusion. The basic idea is that before the tax was imposed, firms ignored the external cost. It makes sense that when a cost is ignored, people wind up doing too much of an action. So, when firms ignored the external cost, they wound up producing too much of the product. Thus when the tax is imposed, firms no longer ignore the cost; they include it in with all their other costs. And, once all the costs are taken into account, the right amount of the action is done, so that firms produce the "right" amount of output, that is, the allocatively efficient amount.

This intuition also carries through to the case of a positive externality, such as occurs in the situation with knowledge. Knowledge has a positive externalty. In this case with the positive externality, demanders ignored some of the benefits. When a benefit is ignored, too little of an activity is done. Hence the unregulated market will produce too little knowledge, that is, less than the allocatively efficient amount of knowledge is produced. To correct the market, the government might decide to subsidize the purchase of knowledge, perhaps by making low-cost loans available to students or by directly funding research.

Understanding how externalities effect market outcomes is Chapter 18. Unless you have a solid understanding of this topic, you will not fully understand the various methods of correcting the problems created by externalities in Chapter 19. Please check that you understand the first Learning Challenge in the Study Guide. Then to be sure that you have a good grasp of this chapter, in the Study Guide work True or False questions 1 to 10; Multiple Choice questions 4 to 18; and Short Answer questions 1, 2, and 3. Be sure not to miss more than a few of these questions. If you do, carefully study the answers given in the Study Guide to be sure that you understand each answer.

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