Which of the following is a possible option to address the issue when demand for a good or service exceeds its capacity, resulting in negative externalities?

• A. Eliminating all government intervention
• B. Subsidizing the production of the good
• C. Imposing a tax equal to the external cost
• D. Increasing the supply without considering external costs

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the problem context. When demand for a good or service exceeds its capacity and causes negative externalities, it means that the consumption or production of that good imposes costs on third parties that are not reflected in the market price.
2. Step 2: Identify the nature of negative externalities. Negative externalities occur when the social cost (private cost plus external cost) is higher than the private cost borne by producers or consumers, leading to overconsumption or overproduction relative to the socially optimal level.
3. Step 3: Review the policy options. Eliminating government intervention or subsidizing production typically do not reduce negative externalities; in fact, subsidies might increase production and worsen the externality. Increasing supply without considering external costs also ignores the externality problem.
4. Step 4: Understand the role of taxes in correcting externalities. Imposing a tax equal to the external cost (a Pigouvian tax) internalizes the externality by making producers or consumers pay for the external costs they impose, aligning private costs with social costs.
5. Step 5: Conclude that the correct approach to address negative externalities when demand exceeds capacity is to impose a tax equal to the external cost, as this reduces demand or production to the socially optimal level and mitigates the negative external effects.