Negative Production Externalities and Efficacy of the Pigouvian Tax Policy in a Developing Economy: A Pure Economic Argument

This theoretical note examines the usefulness of the Pigouvian tax policy in dealing with negative production externalities and in improving social welfare in a small developing economy. A two-sector, full-employment general equilibrium model with exogenous labour market imperfection is used for the analytical purpose where the sector that faces an imperfect labour market creates pollution through its production and lowers the efficiency of workers. The analysis finds that the socially optimal Pigouvian tax rate may not necessarily be positive and that it crucially hinges both on the degree of labour market imperfection and the scale of negative externalities that production of the dirty commodity generates.