Which policy instruments can correct a negative externality by raising private costs toward social costs?

Which policy instruments can correct a negative externality by raising private costs toward social costs?

• A. Taxes (Pigouvian tax) or regulation
• B. Subsidies and deregulation
• C. Price ceilings and non-price rationing
• D. Tariffs and quotas

Answer: (A)

When a negative externality exists, social costs exceed private costs, so too much is produced from the viewpoint of society. The way to fix this is to raise the private cost per unit to match the social cost, nudging the market toward the socially efficient level. A Pigouvian tax does exactly that by charging a per-unit tax equal to the external cost. This makes producers face higher costs, reducing output until the private and social costs align. Regulation works similarly by imposing standards or limits that raise production costs, forcing behavior changes that lower output to the socially optimal point. Subsidies would decrease costs and encourage more production, making the externality worse. Price ceilings and non-price rationing affect pricing or allocation but don’t specifically internalize the external cost. Tariffs and quotas influence trade and quantities but aren’t targeted tools for aligning private costs with social costs in domestic markets.

When a negative externality exists, social costs exceed private costs, so too much is produced from the viewpoint of society. The way to fix this is to raise the private cost per unit to match the social cost, nudging the market toward the socially efficient level.

A Pigouvian tax does exactly that by charging a per-unit tax equal to the external cost. This makes producers face higher costs, reducing output until the private and social costs align. Regulation works similarly by imposing standards or limits that raise production costs, forcing behavior changes that lower output to the socially optimal point.

Subsidies would decrease costs and encourage more production, making the externality worse. Price ceilings and non-price rationing affect pricing or allocation but don’t specifically internalize the external cost. Tariffs and quotas influence trade and quantities but aren’t targeted tools for aligning private costs with social costs in domestic markets.