Correcting Externalities: Taxes, Subsidies & Their Limits
- Determine the corrective tax or subsidy that achieves the socially optimal quantity
- Explain why the correction equals the external effect at the optimum
- Compare Pigouvian taxes with tradable permits and with regulation
Make the decision-maker face the full cost
The problem with an externality is that the decision-maker does not bear the whole consequence. A corrective (Pigouvian) tax on a negative externality adds the external cost to the producer's private cost, so MPC rises to meet MSC and the market quantity falls to the optimum. A corrective subsidy on a positive externality adds the external benefit to the buyer's private benefit, raising MPB to MSB and the quantity to the optimum. The word for this is internalizing the externality.
Why a tax raises revenue and reduces deadweight loss at once
This runs against the intuition built in Unit 2, where a tax on an otherwise efficient market creates deadweight loss. Here the market was already inefficient, so a tax that moves it to the optimum removes deadweight loss while also raising revenue. That is what makes corrective taxes unusual and why economists favor them over most other revenue sources: they are the rare tax that improves efficiency rather than degrading it.
Permits, regulation and the information problem
Tradable permits cap total emissions and let firms trade the right to pollute, so abatement is done by whoever can do it most cheaply — the same efficient outcome as a tax, with the quantity fixed and the price discovered instead of the reverse. Command-and-control regulation mandates a technology or a limit for each firm; it is simpler to administer but usually more costly, because it ignores differences in abatement cost. All three approaches require knowing the size of the external effect, and that measurement problem is the practical limitation on all of them.
When no intervention is needed
The Coase insight is that if property rights are clear and bargaining is cheap, the parties may resolve the externality themselves — a beekeeper and an orchard owner can contract without a regulator. Intervention is warranted where transaction costs are high or the affected parties are too numerous and dispersed to bargain, which is why air pollution is regulated and a noisy neighbor usually is not.
A power plant imposes $30 per megawatt-hour of external damage. Determine the corrective tax and describe the effects on quantity, price and deadweight loss.
- 1.The external cost is $30 per unit, so the corrective tax is $30 per megawatt-hour.
- 2.Supply shifts up by $30, so MPC now coincides with MSC.
- 3.The new market equilibrium is at the socially optimal quantity — output falls.
- 4.The consumer price rises; the plant's net price falls; government collects $30 times the new quantity.
- 5.Deadweight loss from the externality is eliminated, since MSB now equals MSC at the market outcome.
The corrective tax equals the external cost per unit, not the total damage and not the price change. And it is set so that MPC coincides with MSC — an answer that sets the tax to eliminate the activity has overcorrected.
A per-unit tax equal to the marginal external cost achieves the socially optimal quantity because it:
Unlike a tax on a market with no externality, a corrective tax:
Tradable emission permits achieve efficient abatement because:
State the corrective tax or subsidy as a per-unit amount and say explicitly which curve it moves and by how much. "Impose a $30 tax, shifting MPC up to coincide with MSC" earns more than "tax the pollution".
Answer the 3 checkpoints as you read.
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