Correcting Externalities: Pigouvian Taxes, Subsidies and Permits

Making the decision-maker feel the whole cost

Every correction in this unit does one thing: it internalises the externality, forcing the private decision-maker to face the social cost or benefit.

Pigouvian tax. For a negative externality, set a per-unit tax equal to the marginal external cost measured at the socially optimal quantity:

The tax shifts MPC up until it lies exactly on MSC, so the market's own equilibrium now lands on $Q^{*}$ and the deadweight loss disappears.

Pigouvian subsidy. For a positive externality, pay a per-unit subsidy equal to the marginal external benefit at $Q^{*}$. It shifts MPB up onto MSB (or, drawn the other way, shifts supply down), again landing the market on $Q^{*}$.

Tradable permits. Government fixes the total quantity of pollution and lets firms buy and sell the right to emit. Firms with cheap abatement sell permits and clean up; firms with expensive abatement buy permits and keep polluting. The total reduction is guaranteed by the cap, and it is achieved at the lowest total abatement cost — the efficiency argument the free-response question wants.

Coase theorem. If property rights are clearly assigned and transaction costs are negligible, private bargaining reaches the efficient quantity regardless of who holds the right. Who holds it changes who pays whom, not the outcome.