Question

Producing an industrial good causes pollution to a river. Previously, farmers had
used water from the river to irrigate their fields. Which of the following statements
about this externality is not correct?
(a) In the absence of well-defined property rights, the free-market equilibrium
will be inefficient.
(b) The distortion caused by this externality can be corrected using a tax on the
output of the industrial good.
(c) If property rights are fully defined, and markets are complete with no
transaction costs, the free-market equilibrium will be efficient.
(d) The efficient level of pollution is zero.

Answer 1

If no externalities existed, the interaction of demand and supply would coordinate social costs and benefits.

Because externalities represent a case where markets no longer consider all social costs but only some of them, economists commonly refer to externalities as an example of market failure. When there is market failure, the private market fails to achieve efficient output because either firms do not account for all costs incurred in the production of output and/or consumers do not account for all benefits obtained, in the case of a positive externality. In the case of pollution, at the market output, social costs of production exceed social benefits to consumers, and the market produces too much of the product.

In order to deal with externalities, markets usually internalize the costs or benefits. For costs, the market has to spend additional funds in order to make up for damages incurred.

In the absence of well-defined property rights, the free-market equilibrium will be inefficient. The distortion caused by this externality can be corrected using a tax on the output of the industrial good. If property rights are fully defined, and markets are complete with no
transaction costs, the free-market equilibrium will be efficient.

Most people would automatically give the answer that zero pollution would be optimal. However, the optimal level of pollution is not zero; instead, the optimal level is obtained by following our economic decision rule of equating the marginal benefit to the marginal cost.

Incorrect Statement - (d)