Figure16-5Applying a Pigouvian Tax to Perfect Competition with Externalities If instead of directly taxing pollution, an excise tax, T, is applied on the production of the good causing the pollution, then the optimal per-unit Pigouvian tax on output is equal to its marginal external cost at the socially optimal quantity of output. The tax eliminates the deadweight loss of perfect competition by forcing the market to internalize the costs generated by the externality.