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. Increasing barriers to entry for firms in the market
• C. Imposing a tax equal to the external cost
• D. Subsidizing the production of goods that generate negative externalities

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 is inefficient, leading to overproduction or overconsumption of the harmful good.
3. Evaluate each mitigation tactic by considering whether it internalizes the external cost, meaning it makes the producer or consumer bear the full social cost of their actions.
4. Note that ignoring external costs does not internalize them and thus does not reduce economic risk; increasing barriers to entry may reduce competition but does not directly address external costs; subsidizing production encourages more of the harmful good, increasing external costs.
5. Identify that imposing a tax equal to the external cost (a Pigouvian tax) aligns private costs with social costs, incentivizing producers to reduce output to the socially optimal level, thereby reducing economic risk.