Addressing Externalities

Use the graph attached below as a starting point (either download it or print it out). Add curves, labels, etc. to this graph in order to show the following:

1. Show that this good has a $4/unit negative externality (external cost), such as pollution.

2. Shade the area that represents the Deadweight Loss (lost gains from trade) caused by the external cost.

3. Show a tax or subsidy wedge (whichever you think is appropriate) that will solve the problem of the external cost.

4. Show the socially optimal level of production that the Pigouvian tax or subsidy above will help the market to achieve.

You may use software or pencil and paper to complete graph.