Question

Describe how an over allocation of resources results when negative externalities costs are present and how this can be corrected by government action.

Answer 1

Ans) Externality is when the bystander bears the cost or benefit of any activity. It is of two types ÷ positive and negative.

Positive externality is when the bystander bears the benefit of any activity. Eg- education, planting trees etc.

Negative externality is when the bystander bears the cost of any activity. Here, social cost is more than the private cost. And the difference between social cost and private cost is known as external cost. When this external cost is not taken into account, the goods are overproduced. Eg- when factories produce goods, they do not take into account the cost of pollution (external cost) caused by them. This leads to over production of goods.

To correct this externality, government imposes tax equal to external cost. This shifts supply curve to the left and price increases while quantity decreases.

Imposition of tax brings Qmarket = Qefficient.