Externalities & Pigouvian Taxes
When markets ignore third parties, pollution, vaccines, and the tax/subsidy that fixes the price.
The Externalities & Pigouvian Taxes model, in writing
Definition
Costs or benefits that spill over onto people outside the transaction, so private incentives and social value diverge and the market quantity is wrong.
MSC = MPC + external cost ; efficient output where MSC = MSB
The intuition
A factory ignoring its pollution faces costs lower than society's, so it produces too much; a student ignoring the benefits their education gives others buys too little. The fix is to make the spillover private: tax the harm by exactly the external cost (Pigouvian tax), subsidize the benefit, or define property rights and let parties bargain (Coase).
Exam tip
Draw TWO marginal cost (or benefit) curves, private and social, and mark both the market and efficient quantities. The optimal tax equals the vertical gap between them at the efficient output.
Related models in Micro Foundations