Explain externalities and the Pigovian solutions.

Externality is the uncompensated impact of one person’s actions on the well being of a
bystander. If the impact on the bystander is adverse, it a negative externality. If it is beneficial, it
is positive externality. In the presence of externalities, society’s interest in a market outcome
extends beyond the wellbeing of buyers and sellers who participate in the market to include the
well being of bystanders who are affected indirectly. Because buyers and sellers neglect the
external effects of their actions when deciding how much to demand or supply, the market
equilibrium is not efficient when there are externalities. That is, the equilibrium fails to maximize
the total benefit to society as a whole.
Negative Externalities

In the presence of a negative externality, the social cost of the good exceeds the private cost.
The optimal quantity is therefore smaller than the equilibrium quantity

Positive Externality

In the presence of positive externality, the social value of the good exceeds the private value.
The optimal quantity is therefore larger than the equilibrium quantity.

Pigouvian taxes are corrective tax a tax designed to induce private decision makers to take
account of the social costs that arise from a negative externality
 An ideal corrective tax would equal the external cost from an activity with negative externalities,
and an ideal corrective subsidy would equal the external benefit from an activity with positive
externalities

Suppose that two factories—a paper mill and a steel mill—are each dumping 500 tons of glop
into a river every year. The EPA decides that it wants to reduce the amount of pollution. It uses
Corrective tax: The EPA could levy a tax on each factory of $50,000 for each ton of glop it
emits.
Most economists prefer the tax. It is just as effective as a regulation in reducing the overall level
of pollution. If the tax is high enough, the factories will close down altogether, reducing pollution
to zero.
As a result, the paper mill would respond to the tax by reducing pollution substantially to avoid
the tax, whereas the steel mill would respond by reducing pollution less and paying the tax.
Corrective taxes are unlike most other taxes. Most taxes distort incentives and move the
allocation of resources away from the social optimum. The reduction in economic well-being
exceeds the amount of revenue the government raises, resulting in a deadweight loss. By
contrast, when externalities are present, society also cares about the well-being of the
bystanders who are affected. Corrective taxes alter incentives to account for the presence of
externalities and thereby move the allocation of resources closer to the social optimum. Thus,
while corrective taxes raise revenue for the government, they also enhance economic efficiency