pigovian tax

To internalize externality(refer to the word"externality"), Pigou considers
companies that have mistakes should be punished. He proposed a classic method
to make people pay for the externality cost is to levy a Pigovian taxes which
is equal to the negative externality, as is shown in figure 1. Producers who
overproduce are the sides that have mistakes, so they should be punished in the
way of turning tax. By charging producers the tax, the externality cost is
internalized. When imposed Pigovian tax, producers have an incentive to reduce
their production because their cost is increased and profit will be decreased (http://en.wikipedia.org/wiki/Pigovian_tax).
However, in
practice, there exist difficulties to implement Pigovian tax. The amount of
Pigovian tax is determined by the equilibrium where marginal social cost equals
to marginal benefit. This requires us to know the exact monetary value of the loss.
But it is hard to calculate accurate loss because theloss
is usually very complicated and uncertain. The compromising way is to estimate an
approximate loss and make the estimated value be the tax. The closer the
estimated value is to externality cost, the better the effect of the tax will
be.

image source: Qi Shen

by Qi

Externality

Externality, in economics, refers to the extra price of a good which isn't calculated into its market price. Although in theoretical economics, the price of goods is decided both by customers and merchants, reaching a certain point where both of them could get the biggest satisfaction. For example, when purchasing apples with different prices, one would choose the one whose price and quality meet his expectation. In reality, however, market price could not fully present the true value of goods since its potential influence to others is always omitted by people.

There are two kinds of externality, positive externality and negative externality. Positive externality refers to the goods which could cause benefit to one but he has no need to pay for it. For example, a new park is built up next to your house, so you could take exercise, breath fresh air and see beautiful scenery through your window. You don't pay any dollar to the park but you do receive the benefit from it, that's the positive externality of the park. On the contrast, negative externality comes from the goods which cause harm to one but the goods are not required to pay the extra compensation. A new feedlot is set 0.5 mile away from your house, for instance,  and the odors and noise drive you sleepless. From the landowner's view, he just pay the money for running the feedlot without paying for the negative influence on his neighbors and the environment.

How to add external price into its market price is a significant research. Nowadays, for some positive externalities, which come from public goods such as parks and sewers, citizens pay for it in a indirect way--taxes. For those negative externalities, such as the pollution from factories, they need to buy machines to reduce the damage to neighbors.