In the previous post we discussed pigouvian taxes as a possible method to reduce negative externalities. We originally intended to title that post “Pigouvian taxes & subsidies”. For reasons of limited time we decided to split that post in two parts and discuss pigouvian subsidies in another installment.
Whereas pigouvian taxes are meant to discourage causing negative externalities, a pigouvian subsidy would be a reward for creating positive externalities. To recap: an externality is an unintended consequence upon third parties caused by one’s action. A positive externality means that there’s a benefit for third party.
However, by definition people cannot be excluded from enjoying a positive externality, and hence they cannot be charged effectively for their consumption. Consequently there is little incentive for private entrepreneurs to produce such externalities, though society at large would gain from it. Therefore the production of positive externalities is often in under-supply.
One way to counter this, is that the government would create an incentive for creating positive externalities by offering monetary rewards. Though entrepreneurs cannot still charge their “consumer”, they get at least an opportunity to make money from their activities. Needless to say some checks should be implemented to prevent abuse of such subsidies.
A pigouvian tax might, maybe surprisingly, also reduce negative externalities. If a certain good can be produced in two ways, A and B, and one is cheap for a business but has a lot of negative externalities, while the second method is more expensive but has much less negative externalities. In this scenario the government could either tax A or subsidies B. If it would subsidies B, the costs of method B will be lower and if the subsidy is sufficient B will be less expensive than A.
Pigouvian taxes and subsidies are just two tools among many, to regulate externalities. What tool is most appropriate should be decided upon a case-by-case base.