The graph to the right shows a perfectly competitive firm which generates a negative externality, thus SMC > PMC.

    Suppose a Pigouvian Tax (PT) equal to the marginal harm associated with each unit of output is imposed. Most likely, the more pollution the firm generates, the more harm each added unit is likely to cause, so the amount of the tax per unit would be larger as the firm's output increases. Such a tax gives the firm an incentive to produce the socially efficient amount, QAE since it causes the firm to face the full social cost of production. Unfortunately, computing the marginal harm of each added unit of output is extremely difficult if not even downright impossible, making such a tax difficult to apply with the accuracy suggested by the graph.

Copyright © 1995-2004, Inc. - All Rights Reserved