Question

Plot a graph and write a paragraph to show how a Pigovian fee could work. Show two different MACs and discuss whether equi-marginal principle holds. If yes, why? If no, why not?

Answer 1

A Pigovian tax is a strategic effluent fee assessed against private individuals or businesses for engaging in a specific activity. It is meant to discourage activities that impose a net cost of production on third parties; economists call this a “negative externality.

A popular example of a Pigovian-style tax is a tax on pollution. Pollution from a factory creates a negative externality because part of the cost of pollution is borne by third parties nearby. This cost might manifest through dirtied property or health risks.

The polluter only internalizes the marginal private costs, not the marginal external costs. Once Pigou added in the external costs — creating what he called marginal social cost — he argued the economy suffered deadweight loss from excess pollution beyond the “social optimal” level.

The principle of equi-marginal utility explains the behavior of a consumer in distributing his limited income among various goods and services. This law states that how a consumer allocates his money income between various goods so as to obtain maximum satisfaction. This cannot be derived when Pigovian fee is imposed.