Multiple Choice
Which of the following best describes the difference between mandatory and discretionary spending in the context of public solutions to externalities?
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7. Externalities
Public Solutions to Externalities
Multiple Choice
Which of the following can the government use to address an externality?
A
Ignoring the externality and letting the market operate freely
B
Setting the price equal to marginal private cost
C
Subsidizing the production of goods with negative externalities
D
Imposing a tax equal to the marginal external cost
Verified step by step guidance1
Understand what an externality is: an externality occurs when a third party is affected by the production or consumption of a good, and this effect is not reflected in market prices.
Recognize that negative externalities (like pollution) cause social costs to be higher than private costs, leading to overproduction if the market is left to operate freely.
Identify that ignoring the externality or setting the price equal to marginal private cost does not correct the market failure because the external cost is not internalized.
Understand that subsidizing production of goods with negative externalities would worsen the problem by encouraging more production of the harmful good.
Learn that the government can correct the externality by imposing a tax equal to the marginal external cost, which internalizes the externality and aligns private cost with social cost, leading to an efficient market outcome.
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