Incentive schemes operate by providing monetary inducements to firms or consumers to behave in ways that are thought to be socially desirable. The most straightforward example is a pollution tax. Recall the example of a chemical industry producing a harmful pollutant. What happens if a pollution tax, equal to the monetary value of the damage done by an additional unit of the pollutant, is levied on producers for each unit of emissions?

To deduce the consequences of this pollution tax, refer back to Figure 13.4. For simplicity, we suppose that the ration of output to pollution ratio is constant. The horizontal axis can then be read either in units of pollution or in units of chemicals output. The tax is levied at  per unit of pollution, the monetary value of a marginal unit of pollution. This increases post-tax production costs; the marginal cost schedule is raised from PMC to SMC. The externality has been ‘internalised’ into the firms’ cost schedules.

Two consequences follow:

*The firms in the industry will now choose to produce Q2, the socially efficient output.
*As producers bear pollution costs, they have a continuous incentive to reduce the pollution. Firms will invest in pollution abatement as long as the cost is less than the tax avoided. This is exactly what economic efficiency requires.