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Subject ECONOMICS

Paper No and Title 15: Environmental Economics

Module No and Title 11: Pigouvian tax & Carbon Tax

Module Tag ECO_P15_M11

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Why to impose tax for carbon dioxide emission in the environment
4. Why carbon tax?
5. Pigouvian Tax
5.1 Pigouvian Tax with single and multiple polluters
6. Summary

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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1. Learning Outcomes

After studying this module, you shall be able to:

 Learn about carbon tax.

 Understand about Pigouvian tax
 Know about the pigouvian tax with single and multiple polluter.

2. Introduction

In this module, we will talk about the carbon tax, pigouvian tax and this tax with single
and multiple polluters. We will also talk about the classification of environment and how
biotic and abiotic environment depend on each other.

3. Why to impose tax for carbon dioxide emission in the environment

We can classify our environment into biotic and abiotic environment. Biotic
environment consists of all the living things, plants, animals and microorganisms.
Abiotic environment consists of all the physical factors like temperature, water,
gases minerals etc. Both, biotic and abiotic factors depend upon each other. The life
of all the living organisms depend on these physical factors which maintain the
particular level of temperature, humidity etc. required for life. The life is supported
by air, water and land. A protective cover of gases or the air which envelops the earth
is known as atmosphere. It is also one of the physical factors which provide various
conditions to support the life on earth. Atmosphere consists of various gases to
support life by maintaining the temperature and the required combination of various
gases like oxygen which is required for animals to breath and carbon dioxide for
plants. It goes up to the height of 1600 kilometer from the surface of earth.
Atmosphere also protects the earth from unfriendly environment of space for life.

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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Another sphere necessary for life is hydrosphere or water sphere. It constitutes all the
water of earth in the form of streams, lakes ground water etc. The process of
evaporation and condensation forms one of the important cycles also known as water
cycle supporting the life.
Third sphere is Lithosphere which includes the crust and upper mantle of earth which
constitutes hard and rigid outer layer of the earth. The life sphere is known as
biosphere. These four spheres, atmosphere, hydrosphere, lithosphere and biosphere
are the four segments of environment.
The natural environment has certain capacity to absorb the waste material. This
capacity is also known as assimilative capacity. The process of development has also
increased the production of waste. We are continuously adding excessive chemicals
and pesticides to land and water and various gases to air. This addition of waste up to
the assimilative capacity does not harm the environment. But now we have crossed
the level of assimilative capacity and this is dangerous and threat for the life and
future generations. One of the biggest threats is due to increased consumption of
fossil fuels during last few decades. The burning of fossil fuels (Petrol, Diesel, and
Coal etc.) results in the emission of harmful gases which include Carbon monoxide
(CO), Sulphur dioxide (SO2), Carbon dioxide (CO2) and various oxides of nitrogen.
The major part of these waste gases includes CO2. The atmosphere is capable of
absorbing the Carbon dioxide up to certain level but the atmosphere can’t absorb the
excessive emission of carbon dioxide (CO2) beyond its assimilative capacity and this
may change the climate.1 This climate change may have harmful effect on biotic
environment. CO2 is a heat trapping gas. The excessive emission of CO2 results in
greenhouse effect and this effect may increase the temperature of earth. In long run it
may have serious implications by decreasing the productivity of land or excessive
rain or rise in sea water level etc. Hence excessive emission of CO2 creates negative
externality which results in market failure. To achieve efficiency the government has
to interfere by imposing tax on excessive carbon dioxide production.

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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4. Why Carbon Tax

In earlier chapter we have discussed that the negative externality results in market failure
due to excessive production of goods and selling them at lower price. As a corrective
measure the government has to impose the tax or fee on the good producing negative
externality and the subsidy in case of positive externality. The carbon tax is the tax levied
on the emission of greenhouse gases by burning fossil fuels (excessive use of petrol,
diesel, coal etc.) The excise duty on petrol and diesel in India may be considered as an
implicit carbon tax. The higher price due to implicit carbon tax discourages the excessive
consumption and helps in eliminating the impact of externality. Many countries have
imposed the carbon tax on the basis of CO2 emission. For example British Columbia
imposed the carbon tax at the rate of $10(Canadian) per metric ton of CO2 in 2008 and
the official data from the British Columbia’s provincial government shows the reduction
in CO2 emission during initial four years (2008-12). The carbon tax ensures that those
who produce emission pay for it and it also encourages people to use cleaner alternatives
like solar energy, wind energy etc. Hence carbon tax helps to reduce the consumption of
fossil fuels by improving the efficiency in consumption and reducing non-essential use

5. Pigouvian Tax

In 1920 the economist Arthur C Pigou favored the imposition of tax as a corrective
measure to check the pollution, known as pigouvian tax or Pigouvian fee. This tax is to
be imposed on the producers of pollution and is to be set equal to marginal damage. The
imposition of tax is a corrective measure to deal the market failure due to negative
externality. It helps in restoring the Pareto Optimality by imposing tax on pollution. As
shown in fig. 1, the firm emitting pollution does not include the damage to the society
due to pollution which is a negative externality, in its private cost. The point where
marginal private cost (MPC1) of the firm (also the supply curve of the firm) intersects the
marginal benefit curve (MB) (also the demand curve) is efficient point from the firm’s

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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point of view but not from the society’s point of view. This is because the marginal cost
for the society is greater than the marginal private cost of the firm. If a factory disposes
its chemical waste in the river without treating it and this river is the source of water for
the people living in nearby town. Then the people living in this town will have to bear
extra cost for treating this water. Pigou /argued for the imposition of tax on this factory
based on its marginal damage. MD is the marginal damage curve which increases with
every unit increase in production. When MC1 is combined with the marginal damage
(MD) it becomes MSC which is marginal social cost. You would notice that the slope of
MSC is greater than MC1, since it is MC1 + MD which produce MSC. When the Tax was
not being imposed the output was unduly being encouraged, that is, OQ2. But with the
introduction of tax the production comes down to OQ1, which is the optimal level of
production from the society’s point of view because the Marginal Benefit (MB) is equal
to the (MSC) the marginal social cost. The state gains in terms of Tax revenue to the time
of PabP2.
When there was no tax consumers were paying OP. The consumers were enjoying the
consumer surplus at the cost of the society equal to a net value of ‘afe’ because MSC was
higher than the MB. This was due to over production of a polluting product equal to
Q1Q2. After the tax is imposed, this gets eliminated and the society benefits. When a tax
equal to marginal damage will be levied on the firm the firm’s marginal private cost will
increase by the amount of tax as this tax is equal to marginal damage the new marginal
private cost inclusive of tax becomes equal to the marginal social cost. The new
equilibrium point, the point of intersection of marginal benefit and the marginal private
cost (MPC2) inclusive of pigouvian tax is socially efficient point and represents efficient
level of output and the price. Neither the burden of tax will reduce the production of the
firm below the efficient level nor the production of pollution nor is the emission by the
firm more than the optimum level.

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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Figure 1: Efficient Pigouvian Tax

The efficient tax equal to marginal damage for the victims and the marginal saving for
the firm helps to restore the Pareto optimum level of output from market failure. The
shaded area shows the total tax paid by the producer which increases the marginal cost
for the producer. The vertical distance of shaded area is per unit tax. This per unit tax is
exactly equal to marginal damage and marginal saving at the point of their intersection.

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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5.1 Pigouvian Tax with single and multiple polluters

In both the cases of single and multiple polluters we are assuming multiple victims.
In fig 1, we are showing the quantity of a good produced on X axis. This good is
producing negative externality. For example the production of power from a thermal
power plant using coal. The power plant may take certain measures to check the
emission of pollution or it may leave it untreated affecting the people living around
it. Reducing the emission level will require certain expenditures. It is quite possible
the power may use filters or scrubbers or any other method to reduce pollution or the
emission. Hence lower emission increases the cost and higher emission saves from
all such expenditures. If we represent emission on X- axis and savings and costs on
y-axis, the total cost will reduce with the increase in the level of emission. When
total cost is reducing the marginal cost will be negative as shown in fig 2. We can
also say that the firm will save when the total cost is reducing or the marginal saving
is the negative of marginal cost.

MS(e) = - MC(e) ( here e represents the emissions) ……..1

When this thermal plant is producing negative externality in the form of emission
then, in the absence of a tax, there will be overproduction and hence the market
failure. The benefit of emission is negative for the people or we may call it the
damage. Here the damage is a public good not the private good because it is non
rival and non excludable. We can find the optimum level of emission e* by
minimizing the aggregate of total cost and the total damage. For efficiency the cost
of production should be minimum for the firm similarly the damage should be
minimum for the society. When emission is increasing total damage increases but the

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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cost decreases. Hence the point where total cost and total damage are minimum
collectively becomes efficient point.

Minimum of TC(e*) + ∑TD(e*) (TD is Total damage) ……2

We can find the minimum value by taking first order derivative of eq.2 and putting it
equal to zero. The derivative of total cost is marginal cost and the derivative of total
damage is marginal damage.

MC(e*) + ∑MD(e*) =0 → - MC(e*) = ∑MD(e*) from eq. 1 –MC(e*) =

MS(e*)
Therefore for efficient level of emission
∑MD(e*) = MS(e*) ……..3

This efficient level of emission can be achieved by imposing a tax equal to this level
of marginal saving where it is equal to marginal damage. Hence this tax will be
pigouvian tax. Here the firm is single polluter but the victims are many hence the
marginal savings of the firm should be equal to the marginal damage to all the
victims taken together. Here the damage is not a private good but the public good
hence we take the vertical summation of all the individual victims’ damages to find
the total damage. Fig. 2 shows the vertical summation of individual marginal damage
curves. The optimum level of emission is shown by horizontal distance at point A.
This can be achieved by a tax shown by point A.

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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Figure 2: Pigouvian tax with single polluters & multiple victims

Pigouvian tax with single polluter and multiple (Here two) victims. The optimum
level of emission is at point A where marginal saving of the polluter is equal to the
marginal damage of all the victims. Smaller level of emission means higher burden
on polluter and the possibility of Pareto improvement and more emission mean
greater damage for the victims than the saving of the polluter and again the
possibility of Pareto improvement.

When there are more than two polluters the emission will increase. Here we will not
take the vertical summation of the marginal saving curves of the firms as the firms
are the producers of the emission not the victim. We can find the optimum level of
emission e* at the point of intersection of MS(e*) and the MD(e*) curves. Here
MS(e*) is horizontal summation of marginal saving curves of all the polluters, i.e.
MS(e*) = MS1(e*) + MS2(e*). Fig 3 is showing the Pigouvian tax when there are
two polluters and two victims. This can be generalized for the more than two.

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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Figure 3
Pigouvian tax with multiple (Here two) polluters and multiple (Here two) victims. The
marginal damage curve MD of all the victims is the vertical summation of MD1 the
marginal damage curve of first victim and MD2 the marginal damage curve of second
victim while the marginal saving curve MS of all the polluters is the horizontal
summation of marginal saving curve MS1 of first firm and the marginal saving curve MS2
of second firm
Point B shows the efficient level of total emission by both the firms and the Pigouvian
tax. The optimum emission e* is divided as e1* by first firm and the e2* by second firm.
At this point the marginal savings of all the firms are equal hence the marginal costs are
also equal. By equalizing the marginal costs of all the firms we are achieving the Pareto
optimality. Though each firm may have a different marginal cost curves but the marginal
cost at optimum level of pollution should be the same. Therefore Pigouvian tax helps to
achieve efficiency in case of market failure due to the presence of negative externality.

1. The weather conditions which include temperature, humidity etc. prevailing in an

area over a long period of time.

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax
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5. Summary

 Biotic environment consists of all the living things, plants, animals and

microorganisms. Abiotic environment consists of all the physical factors like

temperature, water, gases minerals etc

 The carbon tax ensures that those who produce emission pay for it and it also

encourages people to use cleaner alternatives like solar energy, wind energy etc

The efficient level of emission can be achieved by imposing a tax equal to this

level of marginal saving where it is equal to marginal damage. Hence this tax will

be pigouvian tax

 Pigouvian tax helps to achieve efficiency in case of market failure due to the

presence of negative externality.

ECONOMICS Paper 15: Environmental Economics

Module 11: Pigouvian tax & Carbon Tax