Question

Describe how externalities, market failures, and taxes are related. Why government intervention is usually required to address the economic failure that results, and how taxes are used to fund this?

Answer 1

Sometimes there are negative externalities associated with production of some goods . In these cases the equilibrium level of output that is delivered by the free market is allocatively inefficient . The social cost is higher than private cost in case of negative externalities . There is over production and social cost is not taken into account in free market , this leads to market failure .

A tax that is imposed to rectify a market failure arising out of negative externality is referred to a Pigouvian tax . A tax increases the marginal private cost of production , and thus reduces supply to the level of marginal social costs . Marginal social cost includes the external cost .

So government intervention is required to address the economic failure . In cases of positive externalities , free market tends to under produce . In this case government provide subsidy using the tax revenue fund , this subsidy helps to raise production or supply and thus internalize the positive externality .