Which of the following is a possible option to employ when demand for a good with externalities exceeds its capacity?

• A. Subsidizing consumers to increase demand further
• B. Ignoring the externality and allowing unrestricted access
• C. Setting the price below the equilibrium level
• D. Implementing a tax equal to the marginal external cost

Answer: (D)

Verified step by step guidance

1. Understand the nature of externalities: Externalities occur when the consumption or production of a good affects third parties not directly involved in the market transaction. In this case, the demand exceeds capacity, indicating a negative externality (e.g., congestion, pollution).
2. Recognize that when negative externalities exist, the private market equilibrium does not reflect the true social cost, leading to overconsumption or overuse of the good.
3. Identify policy options to correct the market failure: These include taxes, subsidies, regulation, or ignoring the problem. Subsidizing consumers or setting prices below equilibrium typically increase demand, which worsens the externality.
4. Understand that ignoring the externality and allowing unrestricted access leads to overuse and inefficiency, so it is not a desirable option.
5. Implementing a tax equal to the marginal external cost internalizes the externality by making consumers pay for the social cost of their consumption, reducing demand to the socially optimal level.