Question

Consider a perfectly competitive market for a good with a negative externality. Will the market achieve economic efficiency in the absence of regulation? Justify your answer. (hint: consider rational/marginal analysis)

Answer 1

In the case of the negative externality, the social cost is higher than the private cost. Since the private cost is lower, the market equilibrium quantity is higher than the socially optimum level of output. Therefore, overproduction would take place. In other words, the market will not be able to achieve efficiency i.e. the socially optimal production level in the absence of regulation. Market regulation in the form of a tax would make the private cost equal to the social cost and the output will be equal to the socially optimal level.