Which one of the following statements is not correct?

The market mechanism over-produces a good that generates positive externality.

A cap and trade of pollution permits can be used by the government to achieve the social optimum.

The optimal amount of subsidy in the case of an activity that produces a positive externality is the difference between the social benefit and the private benefit at the optimum.

Tragedy of Commons is an example of negative externality.

Answer is Right!

Answer is Wrong!

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UPSC CDS-1 – 2024

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A) The market mechanism over-produces a good that generates positive externality.

– Statement A is incorrect. A positive externality occurs when an activity provides benefits to third parties not directly involved in the market transaction (e.g., vaccinations benefiting the whole community). In such cases, the social benefit (private benefit + external benefit) is greater than the private benefit considered by market actors. The market mechanism, only considering private benefits and costs, leads to an equilibrium quantity where private marginal benefit equals marginal cost, which is *less* than the socially optimal quantity where social marginal benefit equals marginal cost. Thus, the market *under-produces* goods with positive externalities.
– Statement B is correct. Cap and trade systems are used to control pollution (a negative externality) by setting a cap on total emissions and allowing firms to trade emission permits, leading to pollution reduction being achieved at the lowest cost, closer to the social optimum.
– Statement C is correct. The optimal subsidy for a positive externality is equal to the external benefit at the socially efficient level of output. This external benefit is the difference between the social benefit (including the externality) and the private benefit enjoyed by the consumer/producer.
– Statement D is correct. The Tragedy of the Commons is a classic example of a negative externality, where individuals’ rational self-interest leads to the depletion of a shared resource because the cost of resource degradation is borne by everyone (an external cost).

– Externalities represent market failures where the market price does not reflect the true social costs or benefits of an activity. Governments use various interventions (taxes, subsidies, regulations, market-based mechanisms like cap-and-trade) to address externalities and move towards a socially efficient outcome.

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