Question

Explain why a negative externality in production results in too much of the good being produced from society's perspective, whereas a positive externality results in too little being produced. How, according to Pigou, might such over- and under-allocation of resources be corrected?

Answer 1

There is an external cost involved in case of negative externality which is often goes unaccounted for. Due to this reason the market supply or the private marginal cost as well as the market demand for the private marginal benefit do not incorporate the external cost and produce more than what is desired by the market.

in case of positive externality there is an external benefit of production or consumption which is not accounted for by the market participants. The market supply or the private marginal cost as well as the market demand or private marginal benefit do not incorporate this external benefit and produce less than what is desired by the market.

In order to correct these market failures, a necessary tax is required in case of negative externality and subsidy is required in case of positive externality. This will discourage excessive production when external cost is internalized by the market, as well as it will encourage more production when the external benefit is incorporated by the market.