Business Studies – 6.2.3 External costs and benefits | e-Consult

Pigouvian Tax: A Pigouvian tax is a tax levied on activities that generate negative externalities (like pollution). The tax aims to internalize the external cost by making the polluter pay for the damage they cause. The tax is set at the level where the private cost to the producer equals the social cost (private cost + external cost). This encourages the producer to reduce their polluting activities.

Effectiveness: A Pigouvian tax can be effective in addressing external costs because:

• Internalizes the external cost: The tax forces the producer to consider the full social cost of their actions.
• Incentivizes reduction in pollution: The tax makes polluting activities less profitable.
• Generates revenue for the government: This revenue can be used to fund environmental cleanup or other initiatives.

Advantages:

• Economically efficient: It encourages a reduction in pollution to the socially optimal level.
• Provides a clear incentive for businesses to reduce pollution.
• Generates revenue that can be used for public good.

Disadvantages:

• Difficulty in setting the correct tax level: It can be challenging to accurately estimate the social cost of pollution.
• Potential for regressive impact: The tax could disproportionately affect lower-income households.
• Political opposition: Businesses may lobby against the introduction of a Pigouvian tax.
• Risk of carbon leakage: Businesses may relocate to countries with less stringent environmental regulations.