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Microeconomics practice questions with answers

This page has 15 microeconomics practice questions with full worked solutions, ordered from easy to hard. They cover comparative advantage, elasticity and revenue, consumer choice, production and cost curves, perfect competition in the short and long run, monopoly and price discrimination, externalities and public goods, and game theory. Supply and demand mechanics (equilibrium, price controls, taxes) and elasticity calculations have their own problem sets, linked at the end of the page.

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Problem 1: Opportunity cost and comparative advantage

Difficulty: Easy

In one day, a worker in Country A can produce either 40 kg of wheat or 20 metres of cloth. A worker in Country B can produce either 30 kg of wheat or 10 metres of cloth. (a) Which country has the absolute advantage in each good? (b) Calculate each country's opportunity cost of 1 metre of cloth and of 1 kg of wheat. (c) Which good should each country specialise in, and within what range must the terms of trade lie for both countries to gain?
Show worked solution
(a) Country A produces more of both goods per worker, so it has the absolute advantage in both. (b) Opportunity cost of 1 metre of cloth: in A, 4020=2\frac{40}{20} = 2 kg of wheat; in B, 3010=3\frac{30}{10} = 3 kg of wheat. Opportunity cost of 1 kg of wheat: in A, 2040=0.5\frac{20}{40} = 0.5 metres of cloth; in B, 1030≈0.33\frac{10}{30} \approx 0.33 metres of cloth. (c) A has the lower opportunity cost of cloth (2 kg of wheat versus 3 kg), so it has the comparative advantage in cloth. B has the lower opportunity cost of wheat (0.33 metres of cloth versus 0.5), so it has the comparative advantage in wheat. Each should specialise in that good and trade. Both gain if 1 metre of cloth trades for between 2 and 3 kg of wheat: A then gets more wheat per metre than it could produce itself, and B gives up less wheat per metre than making the cloth would cost it. Absolute advantage does not decide the pattern of trade; comparative advantage does.

Problem 2: Price elasticity and total revenue

Difficulty: Easy

A city museum estimates that the price elasticity of demand for its tickets is −0.3-0.3. It raises the ticket price by 10 percent. Approximately what happens to attendance and to ticket revenue? How would your answer change if the elasticity were −1.8-1.8?
Show worked solution
With ϵD=−0.3\epsilon_D = -0.3: attendance falls by about 0.3×10%=3%0.3 \times 10\% = 3\%. Revenue is price times quantity, so it changes by a factor of about 1.10×0.97=1.0671.10 \times 0.97 = 1.067, a rise of roughly 6.7 percent. Demand is inelastic, so price and revenue move in the same direction. With ϵD=−1.8\epsilon_D = -1.8: attendance falls by about 1.8×10%=18%1.8 \times 10\% = 18\%, and revenue changes by a factor of about 1.10×0.82=0.9021.10 \times 0.82 = 0.902, a fall of roughly 9.8 percent. Demand is elastic, so price and revenue move in opposite directions. Elasticities describe small changes, so these figures are approximations. The elasticity problem set has more practice on this.

Problem 3: Consumer choice: marginal utility per euro

Difficulty: Easy

A student has 24 euros to spend on coffees (3 euros each) and sandwiches (5 euros each). The marginal utility of the 1st, 2nd, 3rd and 4th coffee is 30, 24, 18 and 9 utils; of the 1st, 2nd, 3rd and 4th sandwich it is 50, 40, 30 and 15 utils. Which bundle maximises the student's utility? Show that it satisfies the utility-maximising rule.
Show worked solution
Divide each marginal utility by the price to get marginal utility per euro. Coffee: 303=10\frac{30}{3} = 10, 243=8\frac{24}{3} = 8, 183=6\frac{18}{3} = 6, 93=3\frac{9}{3} = 3. Sandwiches: 505=10\frac{50}{5} = 10, 405=8\frac{40}{5} = 8, 305=6\frac{30}{5} = 6, 155=3\frac{15}{5} = 3. Spend each euro where it adds the most utility: first the units worth 10 utils per euro (1 coffee and 1 sandwich, 8 euros spent), then those worth 8 (a 2nd of each, 16 euros), then those worth 6 (a 3rd of each, 24 euros). The budget is now used up. Optimal bundle: 3 coffees and 3 sandwiches, costing 3×3+3×5=243 \times 3 + 3 \times 5 = 24 euros, with total utility 30+24+18+50+40+30=19230 + 24 + 18 + 50 + 40 + 30 = 192 utils. It satisfies the rule MUCPC=MUSPS\frac{MU_C}{P_C} = \frac{MU_S}{P_S} with the whole budget spent: 183=305=6\frac{18}{3} = \frac{30}{5} = 6. For comparison, 4 coffees and 2 sandwiches (22 euros) gives 171 utils, and 2 coffees and 3 sandwiches (21 euros) gives 174.

Problem 4: Marginal product and diminishing returns

Difficulty: Easy

A bakery with one fixed oven adds workers. Output per day with 0, 1, 2, 3, 4 and 5 workers is 0, 20, 50, 70, 80 and 85 loaves. (a) Calculate the marginal product of each worker. (b) Where do diminishing marginal returns begin, and why? (c) If each worker costs 100 euros a day, calculate the marginal cost of a loaf as each worker is added, and describe the shape of the marginal cost curve.
Show worked solution
(a) Marginal product is the extra output from one more worker: 20, 30, 20, 10 and 5 loaves for workers 1 to 5. (b) Marginal product rises with the 2nd worker (from 20 to 30), because two people can divide the tasks, then falls from the 3rd worker on (30, 20, 10, 5). Diminishing marginal returns begin with the 3rd worker: with the oven fixed, each extra worker has less capital to work with. This is a short-run idea, because at least one input is fixed. (c) With a wage of 100 euros, the marginal cost of a loaf is MC=wMPMC = \frac{w}{MP}: 10020=5\frac{100}{20} = 5, 10030≈3.33\frac{100}{30} \approx 3.33, 10020=5\frac{100}{20} = 5, 10010=10\frac{100}{10} = 10 and 1005=20\frac{100}{5} = 20 euros. Marginal cost first falls and then rises. The shape of the MC curve mirrors marginal product: when MP rises, MC falls, and when diminishing returns set in, MC rises.

Problem 5: Cost curves from a table

Difficulty: Medium

A firm's total cost (TC) at outputs of 0 to 5 units is shown below. Find fixed cost, and calculate average variable cost (AVC), average total cost (ATC) and marginal cost (MC) at each output. At what output are AVC and ATC minimised, and how is MC related to them?Q012345TC5080100114136180\begin{array}{c|cccccc} Q & 0 & 1 & 2 & 3 & 4 & 5 \\ \hline \text{TC} & 50 & 80 & 100 & 114 & 136 & 180 \end{array}
Show worked solution
Fixed cost is total cost at zero output: FC=50FC = 50. Variable cost is VC=TC−50VC = TC - 50, AVC=VCQAVC = \frac{VC}{Q}, ATC=TCQATC = \frac{TC}{Q}, and MC is the change in TC from one unit to the next.Q12345VC30506486130AVC302521.3321.526ATC8050383436MC3020142244\begin{array}{c|ccccc} Q & 1 & 2 & 3 & 4 & 5 \\ \hline \text{VC} & 30 & 50 & 64 & 86 & 130 \\ \text{AVC} & 30 & 25 & 21.33 & 21.5 & 26 \\ \text{ATC} & 80 & 50 & 38 & 34 & 36 \\ \text{MC} & 30 & 20 & 14 & 22 & 44 \end{array}AVC is lowest at Q=3Q = 3 (21.33) and ATC is lowest at Q=4Q = 4 (34). MC cuts both average curves at their minimum points. While MC is below an average, the average falls: the 3rd unit's MC of 14 pulls AVC down from 25 to 21.33. Once MC is above it, the average rises: the 4th unit's MC of 22 lifts AVC to 21.5. The same holds for ATC: MC of 22 is below 38, so ATC falls to 34; MC of 44 is above 34, so ATC rises to 36. ATC reaches its minimum at a higher output than AVC because average fixed cost keeps falling as output rises (from 50 at one unit to 10 at five).

Problem 6: Perfect competition: profit-maximising output

Difficulty: Medium

A perfectly competitive firm faces a market price of 15 and has total cost TC=200+3Q+0.1Q2TC = 200 + 3Q + 0.1Q^2, so its marginal cost is MC=3+0.2QMC = 3 + 0.2Q. Find the profit-maximising output and the firm's profit. What will happen in this market in the long run?
Show worked solution
A price-taking firm maximises profit where P=MCP = MC: 15=3+0.2Q15 = 3 + 0.2Q, so 0.2Q=120.2Q = 12 and Q=60Q = 60. Total revenue: TR=15×60=900TR = 15 \times 60 = 900. Total cost: TC=200+3(60)+0.1(60)2=200+180+360=740TC = 200 + 3(60) + 0.1(60)^2 = 200 + 180 + 360 = 740. Profit =900−740=160= 900 - 740 = 160. Equivalently, ATC=74060≈12.33ATC = \frac{740}{60} \approx 12.33 and profit =(15−12.33)×60≈160= (15 - 12.33) \times 60 \approx 160. On a diagram, profit is the rectangle between the price line and ATC at Q=60Q = 60. Because firms are earning positive economic profit and entry is free, new firms enter in the long run. Market supply shifts right and the price falls, and entry continues until price equals minimum average total cost and economic profit is zero.

Problem 7: Short-run shutdown decision

Difficulty: Medium

A perfectly competitive firm faces a price of 12. At the output where P=MCP = MC (100 units), its average total cost is 14 and its average variable cost is 10. The minimum of its AVC curve is 9. (a) Should the firm produce or shut down in the short run? Compare the losses. (b) Below what price would it shut down? (c) What happens in the long run if the price stays at 12?
Show worked solution
(a) If it produces 100 units: TR=12×100=1,200TR = 12 \times 100 = 1{,}200 and TC=14×100=1,400TC = 14 \times 100 = 1{,}400, a loss of 200. Fixed cost is (ATC−AVC)×Q=(14−10)×100=400(ATC - AVC) \times Q = (14 - 10) \times 100 = 400, and it must be paid even at zero output, so shutting down means a loss of 400. The firm should produce: revenue of 1,200 covers the variable cost of 10×100=1,00010 \times 100 = 1{,}000 and leaves 200 to put towards fixed cost. (b) The short-run shutdown rule is to produce only if P≥min⁡AVCP \ge \min AVC, so the firm shuts down if the price falls below 9. Its short-run supply curve is the part of its MC curve above minimum AVC. (c) In the long run all costs are variable, and a firm that cannot cover average total cost leaves the industry. If the price stays below ATC, firms exit, market supply falls and the price rises until the remaining firms break even at minimum ATC.

Problem 8: Long-run equilibrium in perfect competition

Difficulty: Medium

Each firm in a perfectly competitive industry has total cost TC=100+4q+q2TC = 100 + 4q + q^2, so MC=4+2qMC = 4 + 2q. Market demand is QD=1,000−20PQ_D = 1{,}000 - 20P. Find the long-run equilibrium price, the output of each firm and the number of firms.
Show worked solution
In long-run equilibrium, free entry and exit drive the price to the minimum of average total cost, so each firm earns zero economic profit. Average total cost: ATC=100q+4+qATC = \frac{100}{q} + 4 + q. It is minimised where MC crosses ATC: 4+2q=100q+4+q4 + 2q = \frac{100}{q} + 4 + q, so q=100qq = \frac{100}{q}, q2=100q^2 = 100 and q=10q = 10. Minimum ATC: 10010+4+10=24\frac{100}{10} + 4 + 10 = 24 (check: MC=4+2(10)=24MC = 4 + 2(10) = 24). The long-run price is P=24P = 24. Market quantity: QD=1,000−20(24)=520Q_D = 1{,}000 - 20(24) = 520. Number of firms: 52010=52\frac{520}{10} = 52. If demand later increases, the price rises above 24 in the short run, firms earn profit, and entry adds firms until the price is back at 24. In a constant-cost industry like this one, the long-run supply curve is horizontal at minimum ATC.

Problem 9: Monopoly output, price and deadweight loss

Difficulty: Medium

A monopolist faces demand P=100−QP = 100 - Q and has constant marginal cost MC=20MC = 20 with no fixed costs. Find the profit-maximising quantity, price and profit. Compare output and consumer surplus with perfect competition, and calculate the deadweight loss.
Show worked solution
Total revenue is TR=PQ=100Q−Q2TR = PQ = 100Q - Q^2, so marginal revenue is MR=100−2QMR = 100 - 2Q (for linear demand, MR has the same intercept and twice the slope). Set MR=MCMR = MC: 100−2Q=20100 - 2Q = 20, so QM=40Q_M = 40. The price comes from the demand curve: PM=100−40=60P_M = 100 - 40 = 60. Profit =(60−20)×40=1,600= (60 - 20) \times 40 = 1{,}600. Under perfect competition, P=MCP = MC: 100−Q=20100 - Q = 20, so QC=80Q_C = 80 and PC=20P_C = 20. Consumer surplus: under monopoly 12×40×(100−60)=800\frac{1}{2} \times 40 \times (100 - 60) = 800; under competition 12×80×(100−20)=3,200\frac{1}{2} \times 80 \times (100 - 20) = 3{,}200. Deadweight loss is the triangle between demand and MC over the units the monopolist does not produce: DWL=12×(80−40)×(60−20)=800DWL = \frac{1}{2} \times (80 - 40) \times (60 - 20) = 800. Check: 800+1,600+800=3,200800 + 1{,}600 + 800 = 3{,}200. The monopolist restricts output because selling one more unit means cutting the price on every unit, so MR<PMR < P.

Problem 10: Negative externality and a Pigouvian tax

Difficulty: Medium

In a market, demand (marginal benefit) is P=120−2QP = 120 - 2Q and supply (marginal private cost) is P=30+QP = 30 + Q. Production causes pollution with an external cost of 15 per unit. (a) Find the market outcome and the socially optimal outcome. (b) Calculate the deadweight loss of the market outcome. (c) What tax would correct the externality, and how much revenue would it raise?
Show worked solution
(a) Market outcome: producers ignore the external cost, so 120−2Q=30+Q120 - 2Q = 30 + Q, giving Q=30Q = 30 and P=60P = 60. Marginal social cost adds the external cost: MSC=30+Q+15=45+QMSC = 30 + Q + 15 = 45 + Q. Social optimum: 120−2Q=45+Q120 - 2Q = 45 + Q, so 3Q=753Q = 75, Q∗=25Q^* = 25 and P=120−2(25)=70P = 120 - 2(25) = 70. (b) On the diagram, the MSC curve lies 15 above the supply curve. Between Q=25Q = 25 and Q=30Q = 30, each unit costs society more than buyers value it. At Q=30Q = 30 the gap is MSC−MB=75−60=15MSC - MB = 75 - 60 = 15, so DWL=12×(30−25)×15=37.5DWL = \frac{1}{2} \times (30 - 25) \times 15 = 37.5. (c) A Pigouvian tax equal to the marginal external cost, 15 per unit, makes producers face the full social cost. Supply becomes P=45+QP = 45 + Q, output falls to 25, buyers pay 70 and producers keep 70−15=5570 - 15 = 55. Revenue =15×25=375= 15 \times 25 = 375. The market overproduced because the cost borne by third parties was not in the price.

Problem 11: Public goods and free riding

Difficulty: Medium

Three residents share a street. Their marginal benefits from streetlights are MB1=50−QMB_1 = 50 - Q, MB2=30−QMB_2 = 30 - Q and MB3=20−QMB_3 = 20 - Q euros per light (for Q≤20Q \le 20). Each light costs 55 euros. (a) What is the efficient number of lights? (b) Would any resident buy a light on their own? (c) Which features of streetlights cause this?
Show worked solution
(a) A streetlight is non-rival, so every resident benefits from the same light. The social marginal benefit is therefore the vertical sum of the individual marginal benefits: MSB=(50−Q)+(30−Q)+(20−Q)=100−3QMSB = (50 - Q) + (30 - Q) + (20 - Q) = 100 - 3Q. Set MSB=MCMSB = MC: 100−3Q=55100 - 3Q = 55, so Q=15Q = 15. Check that each marginal benefit is still positive at Q=15Q = 15: 35, 15 and 5 euros, which sum to 55. (b) No. Resident 1 has the highest marginal benefit, and it is at most 50 euros, below the 55-euro cost. Each resident also hopes the others will pay (free riding), so private provision gives zero lights instead of the efficient 15. (c) Streetlights are non-rival (one person's use does not reduce anyone else's) and non-excludable (people who do not pay cannot be stopped from benefiting). This is why public goods are usually financed through taxation. Contrast a private good, where market demand is the horizontal sum of individual demand curves.

Problem 12: Prisoner's dilemma and Nash equilibrium

Difficulty: Medium

Two rival airlines each choose a high or a low fare. Profits in millions of euros are shown as (Airline A, Airline B). Does either airline have a dominant strategy? Find the Nash equilibrium and explain why the airlines end up there even though both would prefer another outcome.B: HighB: LowA: High(8, 8)(2, 10)A: Low(10, 2)(4, 4)\begin{array}{c|cc} & \text{B: High} & \text{B: Low} \\ \hline \text{A: High} & (8,\ 8) & (2,\ 10) \\ \text{A: Low} & (10,\ 2) & (4,\ 4) \end{array}
Show worked solution
Check A's best response to each of B's choices. If B chooses High, A earns 8 from High and 10 from Low, so Low is better. If B chooses Low, A earns 2 from High and 4 from Low, so Low is better again. Low is a dominant strategy for A: it is the best choice whatever B does. The game is symmetric, so Low is also dominant for B. Nash equilibrium: (Low, Low), with profits (4, 4). Neither airline can gain by changing its own fare, given the other's choice. Both would earn more at (High, High), with (8, 8), but that outcome is not stable: each airline could raise its own profit from 8 to 10 by undercutting. Without a binding agreement, individual incentives lead to an outcome that is worse for both, which is the prisoner's dilemma. (Agreements to fix prices are illegal in most countries; in a repeated game, the threat of future retaliation can sometimes sustain high prices.)

Problem 13: Monopoly pricing and elasticity (markup rule)

Difficulty: Hard

A profit-maximising firm with market power has a constant marginal cost of 20. At its chosen price, the price elasticity of demand is −3-3. (a) Use the relationship between marginal revenue and elasticity to find its price and its Lerner index. (b) What would the price be if the elasticity at the optimum were −1.5-1.5? (c) Explain why a monopolist never chooses a point where demand is inelastic.
Show worked solution
(a) Marginal revenue can be written as MR=P(1−1∣ϵD∣)MR = P\left(1 - \frac{1}{|\epsilon_D|}\right). Profit maximisation sets MR=MCMR = MC: P(1−13)=20P\left(1 - \frac{1}{3}\right) = 20, so P=202/3=30P = \frac{20}{2/3} = 30. The Lerner index, a measure of market power, is P−MCP=30−2030=13\frac{P - MC}{P} = \frac{30 - 20}{30} = \frac{1}{3}, which equals 1∣ϵD∣\frac{1}{|\epsilon_D|}. (b) With ∣ϵD∣=1.5|\epsilon_D| = 1.5: P(1−11.5)=20P\left(1 - \frac{1}{1.5}\right) = 20, so P×13=20P \times \frac{1}{3} = 20 and P=60P = 60. Less elastic demand (buyers with fewer substitutes) allows a much higher markup over marginal cost. (c) If ∣ϵD∣<1|\epsilon_D| < 1, then 1−1∣ϵD∣<01 - \frac{1}{|\epsilon_D|} < 0, so marginal revenue is negative. Cutting output would then raise revenue and lower costs at the same time, so profit would rise. A profit-maximising monopolist therefore always operates on the elastic part of the demand curve.

Problem 14: Third-degree price discrimination

Difficulty: Hard

A firm sells the same product in two separate markets, and buyers cannot resell between them. Demand is PA=70−QAP_A = 70 - Q_A in market A and PB=40−QBP_B = 40 - Q_B in market B, and marginal cost is constant at 10. (a) Find the profit-maximising price and quantity in each market. (b) Show that the higher price is charged in the market with less elastic demand. (c) Compare total profit with the profit from charging one price in both markets.
Show worked solution
(a) Set MR=MCMR = MC in each market separately. Market A: MRA=70−2QA=10MR_A = 70 - 2Q_A = 10, so QA=30Q_A = 30 and PA=70−30=40P_A = 70 - 30 = 40. Market B: MRB=40−2QB=10MR_B = 40 - 2Q_B = 10, so QB=15Q_B = 15 and PB=40−15=25P_B = 40 - 15 = 25. (b) Each demand curve has a slope of −1-1, so the point elasticity is ∣ϵ∣=PQ|\epsilon| = \frac{P}{Q}. Market A: 4030≈1.33\frac{40}{30} \approx 1.33. Market B: 2515≈1.67\frac{25}{15} \approx 1.67. Demand is less elastic in A, where the price is higher. The markup rule confirms both prices: 40−1040=0.75=11.33\frac{40 - 10}{40} = 0.75 = \frac{1}{1.33} and 25−1025=0.6=11.67\frac{25 - 10}{25} = 0.6 = \frac{1}{1.67}. (c) Profit with discrimination: (40−10)×30+(25−10)×15=900+225=1,125(40 - 10) \times 30 + (25 - 10) \times 15 = 900 + 225 = 1{,}125. With a single price P≤40P \le 40, total demand is Q=(70−P)+(40−P)=110−2PQ = (70 - P) + (40 - P) = 110 - 2P, or P=55−Q2P = 55 - \frac{Q}{2}. Then MR=55−Q=10MR = 55 - Q = 10 gives Q=45Q = 45 and P=32.5P = 32.5, and both markets are served because 32.5<4032.5 < 40. Profit =(32.5−10)×45=1,012.5= (32.5 - 10) \times 45 = 1{,}012.5. (Serving only market A, at a price above 40, would earn at most 900.) Discrimination raises profit by 112.5. Total output is 45 in both cases, but it is split differently: buyers in A pay more (40 instead of 32.5) and buyers in B pay less (25 instead of 32.5).

Problem 15: Sequential game: entry deterrence

Difficulty: Hard

A potential entrant decides whether to enter a market. If it stays out, payoffs are (entrant 0, incumbent 100). If it enters, the incumbent either starts a price war, giving (entrant −10-10, incumbent 20), or accommodates, giving (entrant 30, incumbent 50). The incumbent announces that it will start a price war if anyone enters. (a) Use backward induction to find the subgame-perfect equilibrium. (b) Is the threat credible? (c) Is there a Nash equilibrium in which the entrant stays out?
Show worked solution
(a) Start at the last decision. If entry has happened, the incumbent compares a price war (20) with accommodating (50), and accommodates. The entrant anticipates this, so it compares entering (30) with staying out (0), and enters. Subgame-perfect equilibrium: the entrant enters and the incumbent accommodates, with payoffs (30, 50). (b) No. Once entry has happened, a price war would cost the incumbent 30 (a payoff of 20 instead of 50), so a rational incumbent would not carry out the threat. A threat that is not in the threatener's interest to carry out is not credible, and the entrant should ignore it. (c) Yes: (entrant stays out; incumbent fights if entry occurs) is a Nash equilibrium. Given the fighting strategy, staying out (0) beats entering (−10-10); given that the entrant stays out, the incumbent's plan is never tested, so it cannot gain by changing it. But the equilibrium rests on a non-credible threat, which is why subgame perfection is the stronger requirement. To deter entry, the incumbent needs a commitment that changes its own payoffs, such as building extra capacity in advance so that a price war becomes more profitable than accommodating.

Frequently asked questions

What topics are on a typical microeconomics exam?

Most introductory microeconomics exams cover supply and demand, elasticity, consumer choice, production and costs, market structures (perfect competition, monopoly, monopolistic competition and oligopoly), market failure (externalities and public goods) and basic game theory; AP Microeconomics also tests factor markets. This page concentrates on firms, market structures, market failure and game theory. Supply and demand and elasticity have their own problem sets.

How does a perfectly competitive firm decide how much to produce?

It produces the quantity where price equals marginal cost, as long as the price is at least the minimum of average variable cost. If the price is below minimum average variable cost, it shuts down in the short run and loses only its fixed cost. In the long run, entry and exit push the price to the minimum of average total cost, where economic profit is zero.

Why does a monopoly produce less than a competitive market?

To sell one more unit, a monopolist has to lower the price on all its units, so its marginal revenue is below the price. It produces where marginal revenue equals marginal cost, which is a smaller quantity than where price equals marginal cost. The units between the two quantities are worth more to buyers than they cost to make, and their lost value is the deadweight loss of monopoly.

What is a Nash equilibrium?

A Nash equilibrium is a combination of strategies in which no player can do better by changing their own strategy, given what the other players are doing. It does not have to be the best outcome for the players as a group: in the prisoner's dilemma, each player choosing their dominant strategy leaves both worse off than if they had cooperated.

What is a Pigouvian tax?

A Pigouvian tax is a per-unit tax equal to the marginal external cost of an activity, such as pollution, at the efficient level of output. It makes the decision-maker pay the full social cost, so the market moves to the quantity where marginal benefit equals marginal social cost and the deadweight loss from the externality disappears.

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