Multiple Choice
Which of the following best describes social costs in the context of externalities?
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7. Externalities
Externalities: Social Benefits and Social Costs
Multiple Choice
Which of the following policies is most effective in addressing the overallocation of resources caused by negative externalities?
A
Eliminating all government intervention
B
Imposing a tax equal to the marginal external cost
C
Providing subsidies to producers
D
Encouraging increased production through price supports
Verified step by step guidance1
Step 1: Understand what a negative externality is. A negative externality occurs when the production or consumption of a good causes a cost to a third party that is not reflected in the market price, leading to overproduction or overallocation of resources.
Step 2: Recognize that the overallocation of resources means that the quantity produced is greater than the socially optimal quantity, because producers do not bear the full cost of their actions.
Step 3: Identify that to correct this market failure, a policy must internalize the external cost, meaning it should make producers account for the external cost they impose on others.
Step 4: Understand that imposing a tax equal to the marginal external cost (also called a Pigouvian tax) increases the private cost of production to reflect the true social cost, thereby reducing output to the socially optimal level.
Step 5: Compare this to other options: eliminating government intervention does not correct the externality; subsidies encourage more production, worsening the problem; price supports also encourage increased production. Therefore, the tax equal to the marginal external cost is the most effective policy.
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