(a) (i) Negative externality occurs when the production or the consumption of a product creates external cost to the society. For example, consumption of cigarettes can result in high possibility of cancer and air pollution.
(ii) Welfare loss occurs when there is a negative externality in the market. There is a loss of welfare when this negative externality is not reflected in the price mechanism.
(b) Graph 1:
Coal fired power stations produce negative externalities such as air pollution and acid rain. As you see in the graph, external costs of air pollution and acid rain are not reflected on the price. The production of electricity by usage of coal should be on the curve MSC, which rightfully reflects the negative externalities of the production. Instead, the curve is on MPC, which does not reflect the negative externaltities. Therefore, this engenders the welfare loss which is colored black in the middle of the graph.
(c) Graph 2:
In order to solve this problem, the government must intervene to overcome this market failure. The best solution to overcome this problem is for the demand for such polluting energy to go down. As you see in the graph 2, as demand goes down, the product becomes much cheaper and the consumption lowers down lessening the negative externalities of air pollution. The government could advertise not to excessively use the energy produced by the coal. However, this sometimes this method would not work. If this method does not work, government should use the last method of taxation on the production of the electricity by coal. This method is less-desirable than the first method. Although the consumption goes down, the price for the electricity goes up. So this would hurt the consumers.
(d) If the government taxes on the power stations producing electricity by coal, it will raise the price up from P1 to P* in the graph 1. This method will hurt the consumers. However, if the government tries to persuade the consumers to lower their consumption of electricity by advertisement, it will both lower the price of the electricity and the consumption. The best way for the government is to persuade the consumers not to consume electricity too much. The method of taxation should be considered as a last resort.