Illustrating the Difference Between a Pigovian Tax and Emissions Fee Using Isoquant and Isocost Geometry

The study of environmental economics is motivated by the idea that pollution constitutes a negative externality. When production costs do not include the harm to human health and the environment, the market price is too low and output levels are too high, relative to the efficient levels. The initial solution to this problem is usually the “the Pigovian tax” on production. However, all subsequent tax analysis focuses directly on emissions. This tends to leave students wondering (a) why discuss Pigou in the first place and (b) why is it better to focus on pollution emissions rather than production. I provide a graphical analysis, using isoquant and isocost geometry, to illustrate that a direct fee on the externality-generating input is more efficient than a tax on output. This analysis is something teachers might consider utilizing to clarify why there is a transition from output taxation to input taxation.JEL Classifications: A22, A23, Q50