Academic journal article American Economist

Simple Pigovian Taxes vs. Emission Fees to Control Negative Externalities: A Pedagogical Note

Academic journal article American Economist

Simple Pigovian Taxes vs. Emission Fees to Control Negative Externalities: A Pedagogical Note

Article excerpt

I. Introduction

Almost all principles of economics texts, public finance texts, environmental economics texts and intermediate microeconomics texts deal with the economics of externalities. (Representative Principles texts: Mankiw (2007) and Frank/Bernanke (2007). Public Finance texts: Anderson (2003), Gruber (2007), Holcombe (2006), Hyman (2008), Steineman, et al. (2005), Stiglitz (2000), and Ulbrich (2003). Environmental texts: Callan and Thomas (2000), Kahn (2005), Keohane/Olmstead (2007) and Tietenberg (2003). Intermediate Microeconomics texts: Besanko/Braeutigan (2005) and Waldman (2004).) The discussion of negative production externalities usually begins by pointing out that the "social cost" of producing goods that entail negative externalities is higher than the "private cost." The authors then point out that the resulting "excess" output can be "corrected" by imposing a tax--often called a Pigovian tax--on the output of the offending product. Many texts continue by pointing out that taxing pollution directly, instead of output, can be more efficient. However, the texts do not show or fully explain why one approach is more efficient than the other. This note offers a straightforward numerical example to illustrate the efficiency gains from taxing pollution directly rather than taxing the output of pollution-generating goods. The example also illustrates why simply ordering firms to reduce the pollution intensity of their products is less efficient than taxing pollution directly. The issue of how to deal with negative externalities is important, because the different approaches discussed in the paper can have significantly different welfare implications.

II. Current Textbook Treatment

Economics textbooks often introduce the concept of negative externalities using an example in which the production of each unit of a good results in a certain amount of external damage. (See, for example, Mankiw (2007, 206-7), Frank and Bernanke (2007, 349-51), Tietenberg (2003, 67-8), Kahn (2005, 47-8), Keohane and Olmstead (2007, 67-70), Callan and Thomas (2000, 86-95), and Besanko/Braeutigan (2005, 638-647).) The example usually shows the competitive market supply curve (Marginal Private Cost) the demand curve (Marginal Private Benefit--equal to Marginal Social Benefit, if there is no externality in consumption) and Marginal Social Cost, equal to the vertical sum of the MPC and the Marginal External Damage (MED). The socially optimal quantity is where MSC intersects MSB, but a competitive market equilibrium quantity will be where MPB (and MSB) intersects MPC. It is a nice application of consumer surplus and producer surplus to show that the competitive market produces "too much" output, resulting in a deadweight loss. The discussion often continues by arguing that to eliminate the deadweight loss the government should impose a "Pigovian" tax equal to the level of MED. (If MED is not a horizontal line, the tax should be equal to the height of the MED line at the quantity where MSC intersects MSB.) A careful graphical analysis of the tax shows that the tax revenue collected plus the gain to pollution victims, when the tax is imposed, exceeds losses to consumers and producers by the amount of the deadweight loss that existed at the unregulated market equilibrium. (Keohane and Olmstead (2007, 134-136), Frank and Bemanke (2007, 358-9), Mankiw (2007, 206-7), and Kahn (2005, 47-8).)

Some texts point out that taxing the output of polluting firms is fully efficient only if the amount of pollution produced per unit of output is immutable (Holcombe (2006, 73-4), Kahn (2005, 47-48), and Keohane and Olmstead (2007, 13840)). If it is possible, at some cost, to reduce the amount of pollution produced per unit of output, then it is not efficient to tax the output of finns. Rather, the pollution should be taxed directly. Some authors, such as Mankiw, do not make this point at all. Mankiw in fact uses the word "Pigovian" to describe the direct taxation of pollution, rather than the taxation of the output of polluting firms. …

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