When there is market failure due to a negative externality,
A) innocent people will suffer since it cannot be corrected.
B) setting price equal to marginal social cost will solve it.
C) the free market produces too little output.
D) externalities have been taken into account.
E) the best solution eliminates the externality entirely.

Question

Quizplus · Accepted Answer

Setting price equal to marginal social cost will internalize the cost of the negative externality, thus correcting the market failure. This is known as a Pigouvian tax or subsidy, and it is considered the most efficient solution to negative externalities. Options A, C, D, and E are incorrect. Innocent people can be protected by internalizing the externality, producing too little output is a consequence of the negative externality, externalities have not been taken into account, and eliminating the externality may not be feasible or cost-effective.

When There Is Market Failure Due to a Negative Externality