PRICE THE HARM.
Put a number on an externality and tax it until the welfare loss disappears, then run an injection through the economy and watch the multiplier do its rounds.
Tax the externality away
FIG. 01 · MARKET FAILURE · 1.3.2 / 1.4.1The third-party cost the firm never pays: the emissions, the congestion, the noise. It is the vertical gap between MPC and MSC.
The tax shifts the firm's own supply curve up. Match it to the external cost and the private and social optima land on the same quantity.
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What the exam wants: Theme 1 asks you to identify the divergence between private and social cost, show the welfare loss triangle between MSC and MSB over the over-produced units, and then evaluate the intervention. A perfectly-set Pigouvian tax drives the triangle to zero — but that requires the government to know the monetary value of the external cost, which is the standard evaluation point: information failure, so the tax is almost always set too high or too low, and the residual triangle here is what that error costs society.
One pound, many rounds
FIG. 02 · MULTIPLIER · 2.6.2Government capital spending, a surge in investment, or a jump in exports — any injection into the circular flow.
Marginal propensity to consume. What is not consumed is saved: MPS = 1 − MPC.
Savings, tax and imports are the three withdrawals. The more of each pound that leaks out, the shorter the chain.
What the exam wants: k = 1 ÷ (MPS + MRT + MPM), and the calculation is only half the marks. The chart shows why: each round is smaller than the last because part of every pound leaks out of the circular flow, so the injection converges on ΔY = k × injection rather than growing forever. Evaluation lives in the assumptions — spare capacity (otherwise the effect is inflationary, not real), no crowding out, and time, since the later rounds take quarters to arrive.