Public Economics: Externalities & Pigouvian Tax

Negative Externality

External cost / unit $20

Government Intervention

Pigouvian tax / unit $0

Without Intervention

Market Q

–

Market P

–

Socially Optimal

Optimal Q

–

Optimal P

–

With Current Tax

Traded Q

–

Tax revenue

–

Deadweight loss

–

DWL eliminated

–

SMC = PMC + external cost. Market equilibrium (no tax) sits where Demand meets PMC — past the socially optimal quantity, where Demand meets SMC. A tax equal to the external cost shifts the effective supply curve up to SMC, restoring the optimal quantity and closing the shaded deadweight-loss triangle.

Demand Private MC Social MC PMC + tax