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The whole point of a pigouvian tax is to force producers to bear an extra cost equal to the total social cost of a good right? But, the problem this presents is, what if the social cost is very high? This means the pigouvian tax must also be high right? And this will be passed onto consumers right? So, if I was a consumer, wouldn't it be much cheaper for me to turn to black market sources as an alternative to the legal source? This result is inefficient, because more than the socially optimal amount is being produced, and this means there are wider negative externalities borne by the rest of us, and the government is starved of revenue from the pigouvian tax that could actually be used to deal with the problem right, further worsening it?

Like for example, let's take some arbitrary good, say timber. The production of timber results in forest destruction right? Well, if we taxed timber and used the money to reforest areas, relocate animals in danger, etc, that can get expensive right? So, for the sake of argument, let's say the cost is sufficiently high that people start looking for black market alternatives. Then more timber is produced, more habitats destroyed, and there is less money to fix it right?

So, what is the efficient solution here? What should be done? If we lower the tax, we won't have enough to deal with the social cost, if we don't lower it, people turn to the black market and we get less revenue. It is a catch 22 right? What is the right policy here?

My first thought was coasian bargaining, but even then there are the problems of transaction costs and market power in the real world.

What can actually be done here? Is there a possibility?

Ideally, only producer profits would be hit because that means costs cannot be passed onto consumers right? And thus no incentive for the black market would exist. But that only works if we could somehow modify the elasticity of a good, and I don't think that's viable right?

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    $\begingroup$ Interesting question, but it isn't necessarily correct to say that timber production results in forest destruction. A forest is a renewable resource. There is a rate of timber harvesting which, in aggregate, exactly offsets the growth and reproduction of the trees, and forest destruction will occur only if harvesting exceeds that level. $\endgroup$ Jun 7, 2022 at 20:23
  • $\begingroup$ Sure, I was just using timber as an example. Insert whatever good you want, from timber to cardboard to cars to weed. This problem could manifest in any of them no? $\endgroup$ Jun 9, 2022 at 17:17

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One simple solution is just more investment in enforcement. It’s not like people can engage in black market freely the same way as in official sector.

In the example with forest government could simply employ park rangers monitoring the activity in the forest. If you make chances of being caught and fines sufficiently high you will deter most black market activity.

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  • $\begingroup$ This was a thought i had, but then I thought about black markets today, like drugs. Enforcement really hasn't worked against the existence of a drug black market. Why would it work against others? $\endgroup$ Jun 7, 2022 at 21:51
  • $\begingroup$ @Robotic_Cow 1. What evidence you have that enforcement does not reduce amount of drugs used? Drug prohibition might have higher welfare losses than benefits and effect might be small since demand is inelastic but I know of no serious policy economist thinking that there is 0 effect of enforcement on drug consumption. 2. Policing wood extraction and policing drugs is not equivalent. Policing drugs can be more costly, drugs can have high value in small quantities, policing forestry is much easier. $\endgroup$
    – 1muflon1
    Jun 7, 2022 at 21:57
  • $\begingroup$ I mean the whole history of the drug war or prohibition proves it right? Banning products in high demand like drugs doesn't work. It really isn't that hard to find or buy illicit drugs these days, and that's due to the nature of a high demand black market product right? $\endgroup$ Jun 9, 2022 at 17:19
  • $\begingroup$ @Robotic_Cow it makes the drugs harder to find than otherwise. In NL where I live you can go to coffee shop and get as much canabis as you want. In US you will still have to go to some shady place and find some dealer. You will also have to pay premium to that dealer for taking the risk. That will make it more expensive to get the drugs and quantity will be lower. In case of drugs it will be lower only by small amount because demand is extremely inelastic, e.g. compare it to medicine if you would heavily tax insulin people would still buy it or they will die. But for wood the effects would be $\endgroup$
    – 1muflon1
    Jun 9, 2022 at 17:27
  • $\begingroup$ large. Demand for wood is elastic so small extra increases in price will lead to large drops in quantities. $\endgroup$
    – 1muflon1
    Jun 9, 2022 at 17:27

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