How would a policy that taxes negative externalities affect consumer and producer surplus?

• A. It reduces quantity and shifts some surplus from producers and consumers to tax revenue; deadweight loss but the externality is corrected.
• B. It increases quantity and shifts surpluses to producers.
• C. It increases total surplus without any deadweight loss.
• D. It eliminates deadweight loss completely.

Answer: (A)

A tax on negative externalities works by raising the private cost of the good, which reduces the quantity traded toward a more socially efficient level. As a result, consumers face a higher price and buy less, shrinking consumer surplus. Producers receive a lower net price, reducing producer surplus. The government collects tax revenue, which captures part of the surplus that used to accrue to buyers and sellers. Because the quantity traded is still not at the fully efficient point unless the tax perfectly mirrors the external cost, some mutual gains from trade are lost, creating deadweight loss. At the same time, the external damage is internalized, so the negative externality is addressed.