Question

Why do externalities cause market failure? What types of government actions or regulations can be used to correct externalities? How do they work?

What is an example of a negative externality and discuss how the government can fix it?

What is an example of a positive externalities and discuss how the government addresses it?

Do you agree with the way in which externalities are corrected?

Answer 1

Externalities cause market failure because there does not exist any market for externalities. These externalities can thus not be priced and hence the output produced by the market is rather not a socially efficient outcome. This happens because the social cost or gain of production of a good is rather ignored in the marginal analysis of a good.

Govt can set up regulations that will either increase the cost of negative externality by tax or subsidize the cost of production of positive externaity so as to push the output level to socially efficient level. Alternatively, it can also set up an output level that is consistent with the socially efficient level- these are also called command and control measure. Govt can also enter the production of public goods.

One example of negative externality could be a factory that is dumping chemicals in a lake which affects the fish yield. The govt can pass a legislation and impose a tax on the factory such that it dumps socially optimal level of chemicals.

One example of positive externality would be that of subsidy in school education. Education is a merit good and its positive effects are rather multidimensional in nature. The govt can subsidize education so that majority of students do not drop out of the schools.

In certain cases, externalities are rather corrected in an optimal manner. However, the best approach to correct externalities in case of small number of stakeholders would be to define property rights. The assignment of property rights can result in negotiations among the relevant parties in a transaction and hence take care of negative externalities. However, due to sheer size of the spillover effects it may not be always possible to correct externalities using assignment of property rights.