Pigouvian taxes are corrective taxes levied on each unit of output an externality-generator agent produces. It is named after economist Arthur C. Pigou, who developed the idea in his book “The Economics of Welfare”, 1920. Pigouvian taxes are used in order to diminish the ugly consequences of externalities, specially in highly polluting industries.
Consider the diagram below, which shows the graphical representation of a negative externality problem using a polluting factory as an example. The horizontal axis or x-axis measures the amount of output produced by the polluting factory and the vertical axis or the y-axis measures monetary units. The marginal benefit curve (MB) represents the marginal benefit of the factory for each level of production which declines as the amount of output increases. The marginal private cost curve (MPC) shows the marginal cost of the factory as output rises. The more the factory produces, the more it pollutes and hence the bigger the negative effects, which is represented by the marginal damage curve (MD). Lastly, the marginal social cost (MSC) represents the total marginal cost for the whole society, and is constructed by adding together the private costs (which directly translate to higher prices) and social costs.
In this scenario, we have a negative externality equal to E, and the equilibrium is set at an output level of QA at a price PA. A Pigouvian tax could be imposed, in order to eliminate such negative externality. This tax would decrease the output produced to QS, and increase price to PS, being this a socially efficient equilibrium. Consumer surplus decreases A+C+F, while producer surplus decreases by area B+D+G. Government will gain a tax revenue equal to area A+B+C+D, drawn in light red in the diagram. Finally, external agents will gain E+F+G. Therefore, the net effect is E:
The negative effects of the externality are therefore eliminated using a Pigouvian tax. However, a critique can easily be made: it looks like Pigouvian taxes reduce the willingness to produce. Indeed, the careful implementation of Pigouvian taxes require them to be imposed on the polluting aspect of the factory, rather than directly impose them on output levels. Obviously, it can be really hard to actually make this distinction.