What is a Pigouvian tax, and how does it correct a negative externality?

• A. A per-unit tax equal to the marginal external cost at the socially optimal quantity.
• B. A subsidy per unit to increase private benefit.
• C. A per-unit tax unrelated to external costs.
• D. A tariff on imports to address externalities.

Answer: (A)

A Pigouvian tax is a per-unit tax set equal to the marginal external cost of the negative externality at the socially optimal quantity. By imposing this tax, the private cost of production rises by exactly the amount of harm it imposes on others, so producers now face the social cost. This shifts the private marginal cost upward to align with the social marginal cost, reducing the quantity from the market outcome to the socially efficient quantity. At the new equilibrium, the price consumers pay plus the tax reflects the marginal social cost, and production occurs where the marginal benefit to society equals the marginal social cost. Other options miss the mark: a subsidy would encourage more production (addressing a positive externality, not a negative one), a tax unrelated to external costs fails to correct the misallocation, and a tariff targets trade rather than internalizing the domestic external damages.