Air pollution caused by cars is very heavy in Los Angeles Wh

Air pollution caused by cars is very heavy in Los Angeles. What would be policy suggestion compatible with the modern institutional and neo-classical perspectives?

Solution

Pollution is a negative externality and the best policy tool to reduce negative externality is imposition of a tax.

In presence of pollution, marginal social cost (MSC) is higher than marginal private cost (MPC). In private market, equilibrium is established by equating MPC with marginal private benefit (MPB). The social optimal, considering the effects and costs of pollution, is obtained by equating MSC with MPB, at higher equilibrium price and lower equilibrium output (consumption).

When an externality (Pigouvian) tax is imposed, MSC increases further by driving a wedge between MSC and MSC with tax, and when this new tax-imbibed MSC is equated with MPB, price further increases and output (consumption) further decreases.