A negative externality is a type of market failure in which an individual does not bear the full cost of a good or service. A good with a negative externality imposes external costs on society beyond those paid for by the consumer. In this example, the socially optimal point is point , where marginal social cost MSC is equal to marginal social benefit MSB. At this level, units of the good are sold for a price . However, the market operates at point because individuals are concerned with their marginal private costs MPC rather than the social costs. We see that the cost per unit for the consumer is lower than the cost per unit to all of society, and the result is over-consumption of the good at level along with deadweight loss DWL, which is the loss to the economy due to transactions that do not occur because a market is not operating at its optimal point. By taxing the good, the government increases the marginal private cost to lower the level of consumption down to the socially optimal .[more]
One example of a negative externality is pollution from automobile emissions. Consumers purchase gasoline for their cars and trucks, but the carbon emissions impose an external cost on the rest of society by means of polluted air. These external costs are not reflected in the cost of gasoline, and consumers purchase more gasoline and pollute more than is socially optimal. To mitigate this externality, the government can impose a tax on gasoline to increase the marginal private cost until the optimal level of private consumption equals the socially optimal level.[less]
The tax is referred to as a Pigouvian tax because economist Arthur Pigou was the first to develop the idea of economic externalities. He argued that when the private cost of a good is lower than the social cost, taxing the good forces the consumer to internalize the social cost, thereby making it more expensive to consume a good and decreasing the level of output to the socially optimal level.
Marginal social cost MSC is the cost imposed on society by the consumption of one additional unit of a good. Marginal private cost MPC is the cost imposed on the individual consumer through the consumption of one additional unit of a good. Marginal social benefit MSB is the gain or benefit to society as a result of the consumption of one additional unit of a good.