ABSTRACT
P to I”‘, not so far round as P’ because the tariff does not fully off-set the externality. The tariff-ridden private costs are shown by J”J” both at P” and also at C”, the consumption point. The consumption distortion inherent in the tariff means that the improved production allocation is now partly off-set by a new consumption misallocation. However, it may be shown that a tariff can always be found to improve on laissez-faire. Thus, in the presence of a production externality, a production tax/subsidy is optimal, but a tariff is second best. The second-best tariff will be at a rate below the first-best production subsidy.
