Pigovian tax


by Silas Barta Jan 24 2016 updated Jan 27 2016

Taxation of negative externalities so that their producers have an incentive to cheaply reduce them

A Pigovian tax (which might be called a "negative externality tax") is one mechanism for ensuring that market behavior more closely matches a social optimum by making producers see some of the cost their actions impose on others.

There are cases where a good produces effects (e.g. pollution) that others end up having to pay to clean up; in such a case, the markets might clear, but produce a net negative; the benefits to the buyers and sellers are far less than the costs to those third parties. The same logic applies to underproduced goods whose creators do not capture the full positive externality the good throws off, in which case the corresponding corrective action would be called a Pigovian subsidy.

Economic model

One can extend the supply/demand model to include preferences of third parties on transactions, rather than simply adding up the preferences of the primary parties. (For example, someone might be willing to pay a certain amount to stop a good's production but for game-theoretical concerns about rewarding extortion.) This inclusion would result in a social demand curve and a social supply curve that factors in the costs and benefits to the third parties.

The Pigovian tax/subsidy is then ideally placed so that producers see an extra cost that makes their supply curve align with the social one.