By: Dennis W. Carlton and Glenn C. Loury


(from Article Introduction)

A central problem of economic policy is to assure efficiency of the competitive process when externalities are present. One traditional method of dealing with an externality is the imposition of a Pigouvian tax (per unit tax) on the externality-generating activity [Pigou, 1927, and Baumol, 1972]. This paper shows that contrary to
widely held beliefs use of such a tax will not in general lead to an efficient allocation of resources in the long run. The source of the inefficiency of the tax is really quite simple. A per unit tax uniformly raises a firm's average cost curve, and therefore leads the firm in the long run to minimize average cost at the same output as in the pre-tax
situation. In general, however, the output that is socially optimal in the presence of externalities is not the output that minimizes the firm's average production costs.1 However, if one supplements the Pigouvian tax with a lump sum tax-subsidy scheme for participating firms, then a socially efficient allocation can be achieved.


Withdrawal of water beyond repleneshible limits or polluting water sources by any kind of water usage (domestic, agriculture or industry) creates externalities that have a societal impact. Usually, since most pricing policies do not factor in the cost of these impacts, the cost is passed on the other stakeholders.

The question of how taxation can be used to make the polluters (including those who use water un-sustainably) needs to be addressed - particularly as water resources become scarcer and the need for judicious use becomes stronger. It becomes further stronger in view of our proposal to evaluate products based on their water footprint - wherein the footprint includes 'grey water footprint based on the contaminants they release into water systems.

This paper therefore, serves as a useful guide to policy makers to design taxation methods that incorporate water footprint evaluations into the pricing of products. It suggests that a combination of a Pigouvian tax and a lump sum tax leads to the most efficient societal allocation of resources.    


- Evaluating the study findings on a situation where water usage is creating a negative externality ( such a water pollution or rapid decline in the water table) 

- Evaluation of comparative impact of Pigouvian and Pigouvian + lump sum tax regimes on the allocation decisions of polluting units.