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A diagram illustrating how a Pigouvian tax corrects a negative externality of production by internalising external costs, shifting supply from MPC to MSC and reducing overproduction.
Demand Curve (MPB = MSB): Represents marginal private and social benefit, assuming no externalities in consumption.
MPC (Supply): Marginal private cost before the tax, reflecting only producers’ private costs.
MSC (Supply + tax): Marginal social cost after the Pigouvian tax, including external costs.
Price Effect: The price rises from Pm to Popt after the tax is imposed.
Quantity Effect: Output falls from Qm to Qopt, reducing overproduction.
Welfare Loss Recovered: The shaded area shows the reduction in deadweight loss as the tax leads to allocative efficiency.
A negative externality of production occurs when firms impose external costs on third parties, such as pollution, which are not included in market prices.
In the free market, output is produced at Qm where marginal private cost (MPC) equals marginal private benefit (MPB), leading to overproduction.
The Pigouvian tax increases firms’ costs by the size of the external cost, shifting the supply curve upward from MPC to MSC (MPC + tax).
After the tax, the market output falls from Qm to the socially optimal level Qopt, where MSC equals MSB.
The green shaded area shows welfare loss recovered, as the tax corrects the market failure and leads to a more efficient allocation of resources.
Explore other diagrams from the same unit to deepen your understanding
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A PPC diagram showing different levels of production efficiency and economic feasibility using combinations of consumer and capital goods.
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A refined circular flow model highlighting the roles of injections and withdrawals in determining national income and economic equilibrium.
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