What to explore
Change parameters and watch the model adjust.
- Demand and private-cost intercepts and slopes
- External marginal effect and the Pigouvian corrective
Intermediate price theory
Externalities and the Pigouvian Tax
A production externality drives a wedge between private and social marginal cost, so the free market over- or under-produces. A Pigouvian tax or subsidy set equal to the external effect restores the social optimum and erases the deadweight loss.
Focus
Private vs social cost, the deadweight-loss triangle, and the Pigouvian fix
See why a market with an external cost or benefit misses the social optimum, and tune a corrective tax or subsidy until the deadweight loss disappears.Interactive diagram
Externalities — explore it instantly
How to read this
When producing a good imposes a cost on third parties, the social marginal cost (MSC) lies above the firm's private marginal cost (MPC). The market settles where demand meets MPC, but the efficient quantity is where demand meets MSC — so the market over-produces. A positive externality flips this: MSC lies below MPC and the market under-produces.
A Pigouvian tax (or subsidy) shifts the cost firms actually face. Set it equal to the external effect and the curve firms face lands exactly on MSC: the market produces the social optimum and the deadweight-loss triangle disappears. Set it too low or too high and a smaller loss remains.
Core ideas
Interpret the mechanics before you chase the graphs.
- An unpriced external effect makes the market quantity diverge from the social optimum.
- Deadweight loss grows with the square of the gap between the corrective and the external effect.
- A Pigouvian tax or subsidy aligns private incentives with social cost.
Learning goals
What this model should help students internalize.
- Distinguish private from social marginal cost when production has an external effect.
- Locate the market quantity and the social optimum, and measure the deadweight loss between them.
- Set a Pigouvian tax or subsidy equal to the external effect to restore efficiency.
Prerequisites
Concepts to review before diving in.
- Competitive equilibrium with demand and supply
- Deadweight-loss and surplus geometry
Next models to study
Keep moving through the track.
Intermediate price theory
Per-Unit Tax Incidence
See how a per-unit tax alters prices on both sides of the market and divides the burden between buyers and sellers.
Intermediate firm theory
Monopoly and Deadweight Loss
Compare a monopolist's price and output to the competitive benchmark, and read off profit and deadweight loss as you reshape demand and cost.
Intermediate price theory
Price Ceilings and Price Floors
Switch between ceilings and floors to see when the policy binds, how traded quantity changes, and where welfare losses come from.