Question

Answer the following questions with short paragraphs. Use economic reasoning to defend it. Make sure to answer all parts!

Do markets over-produce or under-produce negative externalities? Why? How could the government improve such market outcomes?

Answer 1

Externality is an example of market failure where a party which is not direclty involved in the transaction has to bear the cost in the case of negative externality and incures benefit in the case of positive externality. In the case of negative externality it is seen that the markets generally over produce the externality because marginal damage caused to the third party is not taken into consideration by the firm. This can be depicted in the following diagram:

In the diagram above, market efficient level of quantity occurs when Marginal private cost is equal to marginal benefit from the good and Qm is the market efficient level of quantity. On the other hand, socially efficient level of quantity occurs when Marginal Social cost from the good is equal to marginal benefit from the good and Qe is the socially efficient level of quantity. Since Qm > Qe, thus, it can be stated that markets over produce negaitve externalities.

Government intervention can help in improving such outcomes. Government can levy Pigouvian Tax on the producer which is equal to the marginal damage caused by the product and this will shift the MPC curve upwards to MPC + Tax and socially efficient equilibrium in this case is equal to market efficient equilibrium at Qe.

Thus, negative externalities are over produced by the market and can be corrected by using Pigouvain Taxes.