Which of the following mitigation tactics could reduce the economic risk associated with negative externalities?

• A. Ignoring the external costs and allowing the market to operate freely
• B. Subsidizing the production of goods that generate negative externalities
• C. Imposing a tax equal to the external cost
• D. Increasing barriers to entry for firms in the market

Answer: (C)

Verified step by step guidance

1. Understand what a negative externality is: it occurs when the production or consumption of a good imposes costs on third parties that are not reflected in the market price.
2. Recognize that economic risk from negative externalities arises because the market outcome leads to overproduction or overconsumption of the harmful good, causing social costs.
3. Evaluate each mitigation tactic by considering whether it internalizes the external cost, meaning it makes producers or consumers bear the full social cost of their actions.
4. Note that ignoring external costs or subsidizing harmful production does not internalize the externality and can worsen the problem, while increasing barriers to entry may reduce competition but does not directly address the external cost.
5. Identify that imposing a tax equal to the external cost (a Pigouvian tax) aligns private costs with social costs, thereby reducing the economic risk by discouraging excessive production or consumption of the harmful good.