Externality Taxes

The most practiced economic instrument to address market externality is a tax. Those who purchase gasoline are likely to pay the sum of the price required by the gasoline station owner to cover his costs (and any economic profit he has the power to generate) plus a tax on each unit of gasoline that covers the externality cost of gasoline consumption such as air pollution, wear and tear on existing public roads, needs for expanding public roads to support more driving, and policing of roads.

Theoretically, there is an optimal level for setting a tax. The optimum tax is the value of the marginal externality damage created by consumption of an additional item from a market exchange. If each gallon of gasoline causes $1.50 worth ...

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