AP® Microeconomics · Unit 6 · Topic 6.2
Correcting an Externality with a Tax or Subsidy
A corrective tax or subsidy fixes an externality by making price reflect the full social cost or benefit of a good, pushing quantity to the socially optimal level instead of the private one.
When a market has a negative externality, like pollution from a factory, the firm's marginal private cost sits below the marginal social cost. The firm ignores the cost it dumps on everyone downstream, so it produces more than is efficient. A corrective tax, often called a Pigouvian tax, is set exactly equal to the marginal external cost per unit. Once the firm has to pay that tax, its cost curve shifts up until it matches marginal social cost. The firm's own self-interest now leads it to the quantity where marginal social cost equals marginal social benefit: the social optimum.
The same logic runs in reverse for a positive externality. A vaccine market has marginal social benefit above marginal private benefit, because vaccinated people protect others too. Left alone, the market underproduces vaccines. A subsidy equal to the marginal external benefit shifts the demand curve up until it matches marginal social benefit, pulling quantity up to the efficient level. In both cases the government isn't distorting the market away from efficiency, it's correcting a distortion that was already there.
This connects directly to the deadweight loss analysis from supply and demand: an externality itself is a source of deadweight loss, sitting unpriced in the market. A corrective tax or subsidy doesn't create a new wedge between private and social value, it removes the existing one. That is what separates this policy from an ordinary tax on a market with no externality, and it is the reason economists treat corrective taxes as efficiency-improving rather than efficiency-reducing.
Key terms
- Marginal external cost
- The additional cost a unit of production imposes on people outside the transaction, not paid by the firm.
- Pigouvian tax
- A per-unit tax set equal to marginal external cost to correct a negative externality.
- Marginal social cost
- Marginal private cost plus marginal external cost, the full cost of producing one more unit to society.
- Corrective subsidy
- A per-unit payment equal to marginal external benefit, used to fix underproduction from a positive externality.
- Social optimum
- The quantity where marginal social cost equals marginal social benefit, maximizing total surplus.
Watch it explained
- How it worksHow does a per unit tax equal to the external cost slide a market to the social optimum?
- Worked exampleFind the corrective tax for a market whose marginal external cost is 4 dollars per unit.
- How it worksShow me a subsidy equal to the external benefit pulling a vaccine market up to the optimum.
- Common mistakeWhy doesn't a corrective tax create deadweight loss the way an ordinary tax does?
Check yourself
End of topic.