Course

Pigouvian Tax

Instructor: Alex Tabarrok, George Mason University

Pigouvian Tax : Any tax on a good with external costs that makes the supplier's total cost equal to the social cost. This is from the video “ An Introduction to

Pigouvian Tax: Any tax on a good with external costs that makes the supplier's total cost equal to the social cost. This is from the video “An Introduction to Externalities” in the Principles of Microeconomics course.

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Transcript

The idea of a Pigouvian tax after the economist Arthur Pigou first talked about these ideas, is pretty simple. The market equilibrium is down here. The efficient equilibrium is here. The problem is that the suppliers aren't taking into account all the costs of their production. They're not taking into account these external costs.


So, how could we get these suppliers to take into account all of the costs of their production? Well, one way of doing it is to tax them. A Pigouvian tax equal to the external cost makes the private cost plus the tax, the total private cost, equal to the social cost. Let's remember how we can analyze a tax. Remember that one of the ways to analyze a tax is to shift the supply curve up by the amount of the tax. So, if we impose a tax on the suppliers equal to the external cost the supply curve will shift up until the private cost plus the tax is equal to the social cost.


In this case, we will now have the efficient equilibrium will be the same as the market equilibrium. The market will internalize the externality. All of the costs, private cost plus the tax equal to the external cost, will come to be reflected in the price. And because all of the costs are reflected in the price, consumers will buy the efficient quantity of the good. So, that's one way to handle an external cost problem.

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