One way of thinking about the problem of externalities is as a problem in which economic decision makers don't face the full costs or benefits of their decisions. In principle, the problem could be corrected by forcing decision makers to account for the full social costs of their decisions, whether they are firms or consumers.

This is the simple idea behind a Pigouvian tax. If we know the marginal value of the damage caused by a negative externality we can tax the firm or consumer that amount. Such a tax assures that private and social marginal costs are the same and thus the externality is fully considered.

For a positive externality, we could subsidize the behavior which generates the positive externality by the marginal value of the external benefit, again causing the decision maker to face the full social costs of her decisions. In what follows we briefly examine these problem graphically.

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