AP Microeconomics – Market Failure and the Role of Government Practice Test

Pigouvian tax is a per-unit tax set equal to the marginal external cost of the activity. It internalizes the external damage by making producers face the social cost of their output. When applied, the private cost of producing each unit rises by the amount of the external cost, shifting the supply curve upward and reducing the quantity to the socially optimal level where marginal social cost equals marginal benefit. This is used when negative externalities—costs borne by others not reflected in market prices—cause the market to overproduce relative to the social optimum, such as pollution or congestion.

The other options don’t fit: a per-unit subsidy would raise production rather than curb it, a lump-sum tax doesn’t per-unitly address the external damage and thus often doesn’t change the incentive to produce at the efficient level, and a tariff is a trade policy, not a tool for correcting domestic externalities.