Question

how do externalities give rise to government intervention in the market?

Answer 1

Externalities are of two types-Negative and Positive which creates deadweight loss so the government intervenes in the market to correct the situation by imposing taxes or providing a subsidy.

In the negative externality, the third party bears the burden of the economic process such as pollution so that the quantity produced in the market will be greater than the socially efficient quantity and the price would be lower which will lead to an external cost which is borne by the third party. To correct this, the government will impose a tax on the polluter so that the quantity decreases and the price increases which will bring the output to its optimal level where Marginal social benefit = Marginal social cost.

In case of a positive externality, production of goods from an economic process results in positive benefits to the third party such as education which will result in an inefficient quantity as the goods produced will be lower than the socially optimal level. In this case, the government will intervene and provide a subsidy which will increase the production of good to its optimal level.where the marginal social benefit = marginal social cost