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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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Solution Preview

Benefit externalities are positive factors that are created through the production and use of products, not factored into their market price. For example, when a homeowner uses solar energy, they reduce the pollution created by the generation of electricity. However, the person who buys the solar panels may not get a price that reflects this benefit. In other words, the price is higher than it should be.

Cost externalities are negative factors resulting from ...

Solution Summary

Reasons for under- and over- allocation of resources in the face of externalities; when government intervention is warranted.