Which of the following policies is most effective in addressing the overallocation of resources caused by negative externalities?

• A. Eliminating all government intervention
• B. Imposing a tax equal to the marginal external cost
• C. Providing subsidies to producers
• D. Encouraging increased production through price supports

Answer: (B)

Verified step by step guidance

1. Step 1: Understand what a negative externality is. A negative externality occurs when the production or consumption of a good causes a cost to a third party that is not reflected in the market price, leading to overproduction or overallocation of resources.
2. Step 2: Recognize that the overallocation of resources means that the quantity produced is greater than the socially optimal quantity, because producers do not bear the full cost of their actions.
3. Step 3: Identify that to correct this market failure, a policy must internalize the external cost, meaning it should make producers account for the external cost they impose on others.
4. Step 4: Understand that imposing a tax equal to the marginal external cost (also called a Pigouvian tax) increases the private cost of production to reflect the true social cost, thereby reducing output to the socially optimal level.
5. Step 5: Compare this to other options: eliminating government intervention does not correct the externality; subsidies encourage more production, worsening the problem; price supports also encourage increased production. Therefore, the tax equal to the marginal external cost is the most effective policy.