Returning to Problem 2, suppose that good X is a consumption good with a negative consumption extemality (for example, automobiles, which create local air pollution), so the Foreign government imposes a tax of $4 per unit consumed in Foreign. (Recall from basic microeconomics that an optimal response to a negative extemality is a tax equal to the social cost of the extemality, the standard economist's prescription for dealing with externalities. This is often called a Pigouvian tax, after A. C. Pigou, who first proposed it.)
(a) Show diagrammatically how this affects the Foreign import demand curve for good X and changes the world equilibrium, and compute the new world price of good X. (Assume that neither country is using any tariff or other explicit trade policy.)
(b) What effect does Foreign's domestic environmental policy have on producers of X, consumers of X, and social welfare in Home? Would the government of Home be interested in negotiating with Foreign over this policy?
(c) Now suppose that instead of Foreign imposing a domestic consumption tax on good X, it was Home that became worried about the externalities from consuming X, and therefore imposed its own tax of $4 per unit consumed. How would the effect on Foreign compare with the effect of Foreign's tax on Home? (Thre is no need to compute the new equilibrium.)