Refer to the diagram, in which S is the market supply curve and S1 is a supply curve comprising all costs of production, including external costs. Assume that the number of people affected by these
External costs is large. If the government wishes to establish an optimal allocation of resources in
This market, it should
A) not intervene because the market outcome is optimal.
B) subsidize consumers so that the market demand curve shifts leftward.
C) subsidize producers so that the market supply curve shifts leftward.
D) tax producers so that the market supply curve shifts leftward.

Question

Refer to the diagram, in which S is the market supply curve and S1 is a supply curve comprising all costs of production, including external costs. Assume that the number of people affected by these
External costs is large. If the government wishes to establish an optimal allocation of resources in
This market, it should
A) not intervene because the market outcome is optimal. 
B) subsidize consumers so that the market demand curve shifts leftward. 
C) subsidize producers so that the market supply curve shifts leftward. 
D) tax producers so that the market supply curve shifts leftward.

Quizplus · Accepted Answer

In order to internalize the external costs, the government should implement a tax on producers so that the marginal private cost (MPC) aligns with the marginal social cost (MSC) and the market supply curve shifts leftward from S to S1. By doing so, the market equilibrium price will increase and quantity will decrease, resulting in a more optimal allocation of resources. Subsidizing producers or consumers would not incentivize them to internalize the external costs and could potentially lead to a less efficient outcome. Not intervening is also not the best choice because the market outcome is not optimal due to the presence of external costs.

Refer to the Diagram, in Which S Is the Market