Question

The existence of externalities can lead to inoptimal equilibrium if the markets are left to themselves. Based on your understanding of externalities, first, explain negative and positive externalities. How can the government intervene in order to assure a socially optimal equilibrium? Remember to contextualize, define, exemplify, and illustrate relevant concepts.

Answer 1

Externality is a situation in which there is cost incurred or benefits received by a third person by the economic activity of one person.

If there is cost incurred by a person due to the activity of other person for which he is not paid, then this is called negative externality. For example the dirty smoke left by an industry into the air makes people living nearby sick, they incurr cost of treatment but they are not paid by the industrialist.

If there is benefit received by one person due to an activity of other person for which he/she do not pay to other than it is the case of positive externality. For example if a person plants some trees near his hoise, this tree gives oxygen into the air and is used by many other people i.e. they get its benefit but they don't pay anything to the owner of tree.

If the market is left to itself then the presence of these externalities leads to in optimal allocation of resources and there is disequilibrium in market i.e. market failure.

So to obtain a socially optimal equilibrium government have to intervene in the market. Government can take two types of measures to control this externalities.

• First is by imposing a tax or fines on the person creating negative externality so that the amount of negative externality can be minimized.
• Second is by giving monetary incentives or awards and prizes to the people creating positive externality so as to increase the number of positive externality and also there is no loss to the persons providing it.

So by decreasing negative externalites and increasing positive externalities socially optimal equilibrium can be obtained.