Which of the following best explains how foreign investment might be problematic for a transitioning economy in terms of externalities?

• A. Foreign investment guarantees that private and social costs are always equal.
• B. Foreign investment eliminates all market failures in a transitioning economy.
• C. Foreign investment can lead to negative externalities such as environmental degradation, where social costs exceed private costs.
• D. Foreign investment always increases social benefits without any associated social costs.

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the concept of externalities. Externalities occur when a decision causes costs or benefits to third parties that are not reflected in market prices. These can be either positive (benefits) or negative (costs).
2. Step 2: Recognize the difference between private costs and social costs. Private costs are borne by the producer or investor, while social costs include private costs plus any external costs imposed on society.
3. Step 3: Analyze how foreign investment might create externalities in a transitioning economy. For example, foreign firms might exploit natural resources or pollute the environment, causing negative externalities where social costs exceed private costs.
4. Step 4: Evaluate why foreign investment does not guarantee that private and social costs are equal. Market failures can still occur if externalities are not internalized, meaning the market outcome is inefficient.
5. Step 5: Conclude that foreign investment can lead to negative externalities such as environmental degradation, making social costs higher than private costs, which is a common problem in transitioning economies.