The case of an imperfectly competitive firm which generates an externality is a bit trickier because if the firm is taxed or subsidized so as to face the full social cost of production it will under produce in every case.
The graph to the right shows an imperfectly competitive firm which generates a negative externality, so SMC > PMC
. What is needed is a tax, T, just large enough to force the firm onto the MC-Tax curve. MC-Tax = MR curve where the firm shown would produce the allocatively efficient amount, QAE. Because the firm is imperfectly competitive, the tax necessary to induce allocative efficiency is less than the amount of the marginal social harm of the externality.
