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Externalities

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Suppose the U.S. government determines that cigarette smoking creates social costs not reflected in the current price of cigarettes in the market. A study has recommended that the government can correct for the externality given the effect of cigarette consumption by paying farmers not to plant tobacco used to manufacture cigarettes. Assuming that the government is correct that cigarette smoking creates external costs, evaluate where the studyâ??s recommended policies might help correct this externality. Why does the presence of externalities not reflect societyâ??s costs and benefits in the market? Why are markets considered to fail the appropriate allocation of resources that are needed in the market? When answering the question, make sure to evaluate it from the different stakeholders that are present in the market.

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Suppose the U.S. government determines that cigarette smoking creates social costs not reflected in the current price of cigarettes in the market. A study has recommended that the government can correct for the externality given the effect of cigarette consumption by paying farmers not to plant tobacco used to manufacture cigarettes. Assuming that the government is correct that cigarette smoking creates external costs, evaluate where the study's recommended policies might help correct this externality.
The recommended policy might help correct this externality because if the farmers stop growing cigarette tobacco, then there will be very little cigarettes produced. ...

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The Role of the Government with Respect to Externalities

Introduction: It is observed that under perfect competition, an economy's scarce resources are optimally allocated and social welfare is maximized. This situation of perfect competition can prevail only if all the costs of production are accounted for in the price of the product. However, certain production costs are not included in the price of the product. This gives rise to externalities that result in market failure.

Task: Explain the reasons for under-allocation of the economy's scarce resources in case of benefit externalities, and their over-allocation in the case of cost externalities. Do you think that government intervention is necessary to eliminate the effects of externalities?

Arrange your answer as per the following guidelines:

Describe benefit and cost externalities.

List the reasons for lack of optimal allocation of resources in each case.

Explain the need for government intervention in case of market failure due to externalities.

Explain why government intervention may not be needed in certain cases with the
help of the 'Coase Theorem.'

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