2: Assume the production of some good involves the generation of a negative externality. A negative externality occurs when there is a cost inflicted upon a third party of whom are not directly involved in either the production or consumption of a good or service. The result of a negative externality within the market is the social cost of the production of a good exceeding the cost borne by the producer, which consequently causes the output to be significantly higher than the economically efficient amount. In saying this, if there is no internalization of the production of a good with negative externality, the equilibrium output will evidently be higher than the efficient output. For a good that has negative externalities, the cost will be greater to society than the cost that is paid by the consumer. As the market overprovides the good with negative externality, producers are then able to produce more of a good at a price lower than the efficient equilibrium price, which then allows for other alternatives to be sought and to ensure that the public restrict or reduce their use.
The diagram above represents the negative externality of a good, excluding taxes and subsidies. It is evident from this diagram that the optimal equilibrium output is greater than the efficient market equilibrium. The social cost of the good is represented on the diagram with a red line and the green line represents the supply of a product with negative externality. The optimum output is shown through the intersection of the social cost curve and the demand curve. It is evident that the market equilibrium quantity is higher than the social output level. Taxes are implemented to reduce the level of equilibrium to a quantity that is socially acceptable.
Pigovian Tax is levied on companies that are creating excess social costs (negative externalities) through specific business practices. This tax is applied when market economies do not try to reduce negative externalities and the Pigovian tax ultimately aims to level the inefficient market outcome with the implementation of taxes that are equal to external marginal cost. This allows for a change in the market outcome. The tax will shift the private cost supply up to