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The Pigouvian tax

October 16, 2011

The Pigouvian tax is a way of tackling a negative externality. If we consider the case where we have a competitive market and a negative externality, then the competitive market leads to an inefficiently high output level compared to the social optimum. So we want to reduce the output and we can do this with a tax.

The gap between the social marginal cost curve and the private marginal cost curve is the amount of marginal damage caused by the externality.

So if you know the level of marginal damage at the socially optimal amount, you can apply a specific tax (quantity tax) of value t. This shifts the supply curve up by the value of the tax, t, which means that the supply curve will now intersect the demand curve at the socially optimal level.

In reality it is going to be difficult to set the level of a Pigouvian tax exactly right, as you would need to be able to measure the exact about of the marginal damage in order to know the social optimum. However the government may still apply a Pigouvian tax even if it knows it is unlikely to result in the exact socially optimal amount, if it can bring the output level closer to the social optimum than it would have been without the tax then it will at least be a welfare improvement.

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