Multiple Choice
Which of the following best describes a situation where individually rational behavior results in a collectively inefficient outcome due to externalities?
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7. Externalities
Externalities: Social Benefits and Social Costs
Multiple Choice
The objective of imposing a higher pollution tax is to:
A
internalize the external costs of pollution and align private costs with social costs
B
encourage firms to increase their output regardless of environmental impact
C
increase the profits of polluting firms
D
subsidize the production of polluting goods
Verified step by step guidance1
Understand the concept of externalities: Pollution is a negative externality, meaning it imposes costs on society that are not reflected in the private costs of the polluting firm.
Recognize that private costs are the costs borne by the firm, while social costs include both private costs and external costs (like pollution damage).
The goal of a pollution tax is to make firms account for these external costs by increasing their private costs to match social costs. This is called internalizing the externality.
Mathematically, if \( C_p \) is the private cost and \( C_e \) is the external cost, the social cost \( C_s \) is given by:
\[ C_s = C_p + C_e \]
By imposing a tax equal to the external cost \( C_e \), the firm’s private cost becomes \( C_p + \text{tax} = C_s \), which aligns private incentives with social welfare and reduces overproduction of pollution.
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