Question

What is the difference between a real externality that is positive and one that is negative?How did Pigou recommend dealing with each?In each case, how would his economic incentive be calibrated?

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Answer 1

When parties are involved in a transaction and it affects the 3rd party but this influence on the third party is not taken into consideration or doesn't reflect in the price. This is referred to as externality. There are 2 types, positive and negative externality. A positive externality is vaccinations and education, whereas negative externality is loud music affecting the neighbors or polluted water released by industry into river streams.

for the optimum point in a negative externality, one needs to take into consideration the marginal external cost(MEC)-

MPC+MEC=MSC

MSC=MSB

For the optimum point in a positive externality, one should consider the marginal external benefit (MEB)-

MPB+MEB=MSB

MSB=MSC

Pigou recommended to deal with the negative externality with a tax (corrective tax) and to deal with positive externality with a subsidy , therefore termed as Pigovian taxes and subsidies.

The tax amount would be equal to the marginal external cost which would increase the cost of the production hence inducing the firm to reduce the quantity produced hence reducing the emission. Tax on polluting firm

The subsidy would be equal to the marginal external benefit which will be provided by the authorities so as to increase the benefit of this externality. For instance, vaccination provides a positive externality hence although the cost is $30 but provides a subsidy of $20 so that everyone has an incentive to take the vaccination at $10.