CFA Level II ExamEconomicsEasy
An economist is analyzing the optimal level of government intervention in an industry characterized by significant positive externalities, such as basic scientific research. From a social welfare perspective, what is the most appropriate policy response to address this market failure?
- ANationalization of the industry, to ensure public control over production decisions.
- BProvision of government subsidies to producers or consumers to encourage more production/consumption.
- CDeregulation, to allow market forces to determine the optimal production level.
- DImposition of a Pigouvian tax on the industry to internalize the external costs.
Show answer & explanationAnswer & explanation
Correct answer: B. Provision of government subsidies to producers or consumers to encourage more production/consumption.
Positive externalities (e.g., benefits from basic research that spill over to society) lead to underproduction from a social welfare perspective, because private agents only consider their private benefits. Government subsidies can bridge the gap between private and social benefits, encouraging more production or consumption up to the socially optimal level, thereby correcting the market failure.
Why the other options are wrong
- A. Incorrect. While nationalization is a form of intervention, it's a drastic measure and not necessarily the most efficient or appropriate response to correct a positive externality; subsidies are a more targeted solution.
- C. Incorrect. Deregulation would worsen the market failure by removing any existing incentives or regulations that might mitigate underproduction.
- D. Incorrect. Pigouvian taxes are used to address negative externalities (external costs), not positive externalities.
Positive Externality
A benefit from an economic activity that accrues to a third party not directly involved in the transaction.
- Leads to underproduction from a social perspective.
- Examples include basic research, vaccinations, education.
- Can be addressed with subsidies or public provision.
Memory trick: Externalities: Good gets a boost, Bad gets a tax.