Question

1) Economic theory states that if a good causes a negative externality to society, then to make sure there is a socially optimal amount it should be ___________.

A) subsidized

B) taxed or regulated

2) Economic theory states that if an item provides a positive externality to society, then to make sure there is a socially optimal amount it should be [___________.]

A) Taxed

B) subsidized

Answer 1

1B) Taxed or regulated

2B) Subsidized.

If a good has a negative externality then the socially optimal amount that should be produced will be less than the market equilibrium as the market will not take into account the negative externalities which are the external costs of production like pollution etc. Thus it should be taxed so that the amount produced is reduced to the socially optimal level.

Similarly if a good has a positive externality, then the socially optimal amount that should be produced will be more than the market equilibrium as the market will not take into account the positive externalities (External benefits of production) this time. Thus it should be subsidized so that the amount produced is increased to the socially optimal level.

Hope it helps. Do ask for any clarifications if required.