Which one of the following statements is not correct?
The market mechanism over- produces a good that generates positive externality.
Identifying the Incorrect Statement on Market Mechanisms and Externalities
This solution analyzes the provided statements about economic externalities to identify the one that is not correct. We will examine each statement concerning market mechanisms, positive and negative externalities, and government interventions like subsidies and cap-and-trade systems.
Analysis of Market Behavior with Externalities
Externalities occur when the production or consumption of a good affects third parties who are not directly involved in the transaction. Understanding how markets respond to these effects is crucial.
Statement 1: Market Mechanism and Positive Externalities
Statement: The market mechanism over- produces a good that generates positive externality.
Explanation: A positive externality benefits third parties. Examples include vaccinations or education. In such cases, the social benefit (which includes private benefit plus external benefit) is greater than the private benefit considered by the market. Because the market only accounts for private benefits, it leads to a lower quantity being produced and consumed than is socially optimal. Therefore, the market mechanism actually under-produces goods with positive externalities, rather than over-producing them. This statement is incorrect.
Statement 2: Cap and Trade for Social Optimum
Statement: A cap and trade of pollution permits can be used by the government to achieve the social optimum.
Explanation: Pollution is a classic example of a negative externality, where production imposes costs on third parties. A 'cap and trade' system limits the total amount of pollution (the cap) and allows firms to trade permits to pollute. This creates a market price for pollution, encouraging firms to reduce emissions efficiently. By setting the cap at the socially optimal level of pollution, this mechanism helps achieve the social optimum. This statement is correct.
Statement 3: Optimal Subsidy for Positive Externalities
Statement: 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.
Explanation: To correct for underproduction caused by a positive externality, the government can provide a subsidy. The optimal subsidy should equal the marginal external benefit (MEB) at the socially optimal quantity (\(Q_{social}\)). The MEB is precisely the difference between the social marginal benefit (SMB) and the private marginal benefit (PMB) at that quantity (\(SMB - PMB = MEB\)). This subsidy bridges the gap between private incentives and social benefits. This statement is correct.
Statement 4: Tragedy of Commons and Negative Externality
Statement: Tragedy of Commons is an example of negative externality.
Explanation: The 'Tragedy of Commons' describes a situation where a shared, limited resource (like a fishery or pasture) is overused because individuals, acting in their own self-interest, do not bear the full cost of their actions. The depletion of the resource due to overuse imposes costs on all users, representing a negative externality. Each user benefits individually from exploiting the resource more, but the collective action leads to its degradation. This statement is correct.
Conclusion
Based on the analysis, the statement that incorrectly describes the market's response to externalities is the first one. Markets tend to under-produce goods with positive externalities, not over-produce them.
The incorrect statement is:
- The market mechanism over- produces a good that generates positive externality.
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