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xes and subsidies to align private incentives with social efficiency. ? Pigovian taxes are taxes enacted to correct the effects of a negative externality. Examples of Regulation versus Pigovian tax ? If the EPA decides it wants to reduce the amount of pollution ing from a specific plant. The EPA could… – tell the firm to reduce its pollution by a specific amount (. regulation). – levy a tax of a given amount for each unit of pollution the firm emits (. Pigovian tax). Marketbased Policies ? Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. ? A market for these permits will eventually develop. ? A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost. The Equivalence of Pigovian Taxes and Pollution Permits... Quantity of Pollution 0 Price of Pollution P Q Demand for pollution rights Pigovian tax (a) Pigovian Tax 2. ...which, together with the demand curve, determines the quantity of pollution. 1. A Pigovian tax sets the price of pollution... Quantity of Pollution 0 Q Demand for pollution rights Supply of pollution permits (b) Pollution Permits Price of Pollution P 2. ...which, together with the demand curve, determines the price of pollution. 1. Pollution permits set the quantity of pollution... Summary ? When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. ? Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. ? Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity. Summary ? Those affected by externalities can sometimes solve the problem privately. ? The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently. ? When private parties cannot adequately deal with externalities, then the government steps in. ? The government can either regulate behavior or internalize the externality by using Pigovian taxes.