The Economics 207 chapter discusses "Market inefficiencies: Externalities and Public Goods" The 2 part question is:...

The Economics 207 chapter discusses "Market inefficiencies: Externalities and Public Goods"

The 2 part question is:

a) If there is a positive externality associated with a market activity and the government does not intervene to correct for it, what will be the result of the market activity in terms of efficiency...overallocation or underallocation of resources to the market activity? Discuss your answer.

b) If there is a negative externality associated with a market activity and the government does not intervene to correct for it, what will be the result of the market activity in terms of efficiency....overallocation or under allocation of resources to the market activity? Discuss your answer.

Expert Solution

a) When a market activity has positive externality, then it means that the marginal social benefit is more than the marginal private benefit (for positive externality in consumption) or that marginal social cost is less than marginal private cost (for positive externality in production). The private market outcome allocates resources to only produce the quantity that full fills the private outcome which is a lower quantity level (due to lower private benefit/higher private costs). Social benefit/cost is not considered when government does not intervene. This leads to lower quantity being produced than what is socially desirable. Hence there is underallocation of resources. In presence of government, they could provide certain subsidy which would increase quantity produced to socially optimal level and then only resources would be fully and efficiently allocated.

b) When a market activity has negative externality, then it means that the marginal social benefit is less than the marginal private benefit or marginal social cost is more than marginal private cost. The private market outcome allocates resources to produce the quantity that full fills the private market outcome. This leads to a higher quantity being produced (as private cost is lower/ private benfit is higher) than what is socially desirable. Hence there is overallocation of resources. In presence of government, they could tax the activity which would decrease quantity produced to socially optimal level and then only resources would be fully and efficiently allocated.

Rahul Sunny answered 8 months ago

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