Externalities and Pigovian tax

An externality is the impact of the consumption choices made by a person or the production choices made by a firm on other people who are in no way related to these actions. It may also be termed as an unintended consequence. Externalities may be positive or negative.

Instance of a negative externality is the air pollution caused by a vehicle. This air pollution does not affect just the person who was driving but others as well. Decrease in crime rate over the long term owing to better education facilities in an area can be termed as a positive externality.

Pigovian fee or tax was proposed in the early twentieth century by Arthur Pigou, an English Economist. For a firm or an individual involved in an activity which pollutes the atmosphere, the cost of the activity is much smaller than its social cost. In order to introduce a factor that allows for some restraint on such activities, a tax is a valid consideration. This is because the Pigovian fee increases the cost of the activity performed for an individual or a firm.