Plain Sense Economics

In my earlier post on Externalities I mentioned that one form of government intervention to correct a negative externality is a Pigovian tax. Named after the English economist A.C. Pigou (pee-GOO), this tax attempts to bring outside, social costs into the decision that a seller makes in a market.

“…come again?…” Here’s what I mean…. Let’s assume that a coal burning electric power plant produces pollution as a by-product of power generation. The pollution imposes costs on the neighbors – impacting quality of life, or health issues, property values, etc. So the pollution represents a negative externality. Instead of using direct government regulation, where laws and regs require certain actions, a different option is to add a tax that matches the external costs being created. If there are $50 million in external costs a tax of $50 million is imposed. Ideally this tax goes up and down with the amount of pollution released. Here’s the Wikipedia write-up.

If done correctly this Pigovian tax will change the behavior of the producer – the electric power plant. They will adjust their output (usually lower) based on the various theories on how producers choose optimum output. The important point is that those external costs are now being considered, rather than ignored.

Two important points about a Pigovian tax. First, there is a direct financial impact on the producer, but they are left with the option on how to minimize the tax. They can choose smoke stack scrubbers, or they can look for a better coal, or they can reduce output. The choice is theirs and in theory they will make a more efficient choice than a standard solution required by the government. The other important point is that funds are collected by the tax and can be used to reimburse those harmed by the pollution.

There is one remaining downside to a Pigovian tax. Like many such taxes, there is deadweight loss, where the combined consumer surplus and producer surplus show a net loss after the imposition of a tax. Here we have to weigh the relative importance of the deadweight loss against the importance of trying to solve the negative externality.

Greg Mankiw (currently teaching at Harvard and previously chair of the President’s Council of Economic Advisors under Bush) is a fan of the Pigou solution and has formed an informal Pigou Club. See this post for a recent example, from a candidate for the U.S. Senate in New Hampshire.