Arthur Cecil Pigou: externalities and the answer to climate change

Taylor Nugent


August 1st, 2016

Prices contain an immeasurable amount of information. They are the sum of an entire population’s private preferences and an indispensable signal to achieve an efficient allocation of resources. But what about the information they don’t include? Taylor Nugent examines the work of Author Pigou on externalities, and concludes that his eponymous tax is the best way to make prices reflect the costs of climate change.

This article first appeared in Short Supply 2016 – check out the full magazine via the Short Supply tab at the top of this page!

Arthur Cecil Pigou remains an underappreciated contributor to the economics discipline. Deeply involved in Cambridge University economic thought throughout its most influential years from the late 1800s through to the work of John Maynard Keynes, his contribution to the field is even greater than his own research. Pigou pioneered the discipline of welfare economics, with his most enduring contribution being the conceptualisation of a corrective tax, eponymously referred to as a Pigouvian tax. The Pigouvian tax has recently seen renewed relevance, being considered by many as the most suitable policy response to climate change. It is that which will be the focus of this article.

Pigou was heavily influenced by the economics of Alfred Marshall, who popularised the use of supply and demand schedules, being the first to link changes in prices and consumer and producer welfare to shifts in these schedules. During Pigou’s long tenure as Professor of Political Economy at Cambridge, a position he held from 1908 to 1943, Marshallian economics formed the basis for Pigou’s teaching. Marshall had suggested that in industries with increasing returns – that is, an increase in input leads to a more than proportional increase in output – competitive markets may result in underproduction.

Pigou’s research built on this foundation. He focused on the production side and how one firm’s production decision changes the cost structures of other firms in the industry, with implications for the market supply curve. Accordingly, the market supply curve is not merely the sum of all individual firms’ supply curves, because one firm’s production decisions impact the supply options of other firms. As a result, supply curves need to be adjusted for these externalities. The most enduring area of his work, however, took these ideas further. He showed that, because of externalities, producer and consumer surplus were not representative of the welfare of the whole of society.

An externality is any cost imposed on or benefit accrued to a third party who is not involved in a transaction. Producer and consumer surpluses derived using supply and demand curves only measures benefits accrued to the parties of the transaction. Thus, externalities are not included. Smoking contains a negative externality, for example, because people affected by second hand smoke are incurring a cost that was not reflected in the price between the smoker and the cigarette seller. The net benefit to society of this transaction is smaller than the smoker’s personal net benefit of smoking that cigarette. As consumption and production decisions are made removed from the broader impact of society, it is overconsumed.

Pigou reconceptualised supply and demand, considering instead private marginal benefit and collective marginal benefit on the demand side, and private marginal cost and collective marginal cost on the supply side. The Marshallian demand and supply analysis reveals the price and quantity supplied in the market are set by the intersection of the private marginal benefit and private marginal cost curves. This is the point at which the two parties to the transaction both maximise their welfare. Pigou showed that this point was distinct from the point at which the welfare of society was maximised, which was the intersection of the collective marginal benefit and cost curves. The vertical distance between these curves is the positive or negative externality from the transaction. [1]

Pigou’s work strongly influenced Harvard economist N. Gregory Mankiw. In 2006 Mankiw started the Pigou Club to campaign for a Pigouvian tax as a response to the issue of global climate change. [2]
A Pigouvian tax is a tax to offset the negative externality of climate change from carbon emitting activities. A tax of this sort has the effect of moving the marginal private cost of emitting one unit of pollution upward to the marginal collective cost, which in turn would reduce production of carbon emissions and increase the price of consuming goods that pollute the environment.

Such a policy has a lot of support among economists. Nonetheless, other economic initiatives have been proposed to tackle climate change.

The ‘cap and trade’ mechanism sets limits on carbon emissions, with companies able to trade carbon allowances. In comparison to a cap-and-trade scheme, which has very similar effects, a Pigouvian carbon tax would provide ongoing revenue to the government, which could be used to reduce other taxes or fund other worthwhile projects. From an international perspective as well, agreement on a carbon tax should theoretically be more achievable than a cap-and-trade system because revenue could go to national governments, whereas a global cap-and-trade would necessarily include a transfer of wealth from one country to another. If permits were allocated on historical pollution, we would likely see a transfer of wealth from developing countries to the USA, for example. If it were based on population, a transfer of wealth would occur from developed countries to China and India. It is unlikely either of these outcomes would be universally agreeable.

Alternatively, ‘direct action’ is the Coalition government’s favoured policy. The Government’s Direct Action Plan, which involves paying polluters to reduce emissions, essentially creates a market for Coasian bargaining. Coasian bargaining is named after Ronald Coase, who argued in 1960 that, in the absence of transaction costs, the market allocation would always be efficient, even with the existence of externalities. [3]
In other words, the cost of the externality would already be included in the production and consumption decisions of parties to the transaction. This is because with clearly defined property rights, affected third parties can bargain to achieve an efficient outcome. This remains an effective critique of Pigou’s work, as it demonstrates that externalities can be included in prices without intervention, and that collective marginal costs and benefits are not necessarily different from private marginal costs and benefits.

Importantly, an efficient outcome is achieved regardless of who holds the property rights. Take for example, a polluted river. Whether those downstream on a river pay to prevent its pollution, or the polluter pays those downstream to pollute it, the optimal level of pollution is found by the market. Coase used this to argue against government intervention, and his ideas work best in concentrated markets like the river example. However, because effects of climate change are so diffused both geographically and over time, such a market does not exist. With direct action, the government effectively acts as broker for all those affected, representing everyone affected by pollution in bargaining with the polluter. Perversely, however, the right to pollute the environment is owned by corporations, and direct action sees society paying them to refrain from polluting. The underlying premise is that wealth should be transferred from current and future populations to polluters up to the value citizens collectively place on a healthy climate. In contrast, a Pigouvian tax would be fairer, forcing polluters, rather than the public, to pay the cost of their damage to the environment.

Apart from Coase’s critique, the main argument against Pigouvian taxes is that externalities are hard to measure. The distortive effects of an incorrectly set tax, especially combined with the administrative costs of implementation, outweigh any potential benefit. Pigou himself accepted that, more often than not, this would be the case. But with the costs of pollution and climate change so large and widespread, the wrong increase in the cost of pollution is almost certainly better than none at all.


[1] Aslanbeigui, N., & Oakes, Guy. (2015). Arthur Cecil Pigou (Great Thinkers in Economics).

[2] Mankiw, N. (2009). Smart Taxes: An Open Invitation to Join the Pigou Club. IDEAS Working Paper Series from RePEc, IDEAS Working Paper Series from RePEc, 2009.

[3] Coase, Ronald H. (2013). The problem of social cost. Journal of Law and Economics, 56(4), 837-877.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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