Edited by Mark Blaug and Peter Lloyd
Chapter 15: The Taxation of External Costs
Yew-Kwang Ng THE TEXTBOOK DIAGRAM External effects are prevalent, especial in their negative forms like environmental disruption. The idea of taxing goods producing important external costs may be traced at least to Pigou (1912/1932). The simple diagram of Figure 15.1 illustrating the efficiency gain is available in most first or second-year principles of microeconomics textbooks. The horizontal and vertical axes represent respectively the quantity and price of a good. In the absence of a tax on this good, the market equilibrium is at the point A where the market supply curve S and demand curve D intersect. Assuming perfect competition, the supply curve reflects the private marginal costs (MC) of producing the good, that is, MC to the producers. If the production or consumption of the good involves important external costs such as pollution, the additional costs of pollution are largely external to the producers. Adding these external MC to the private MC of production results in the social MC being reflected by the curve S’. If a Pigovian tax in accordance to the external MC is imposed on the production of the good, the market supply curve shifts from S to S’, reflecting the social MC (private MC plus external MC). From the social point of view, the efficient amount of output is at the intersection of the demand curve (reflecting social marginal benefits, assuming no other factors causing inefficiency) with the social MC curve S’ at the point B, with output level Q2. The excess amount of output...
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