One way the government solves problems caused by externalities is by:

• A. setting prices based solely on consumer preferences
• B. eliminating all private property rights
• C. allowing markets to operate without any intervention
• D. imposing taxes or subsidies to align private incentives with social costs or benefits

Answer: (D)

Verified step by step guidance

1. Understand the concept of externalities: Externalities occur when a third party is affected by the production or consumption of a good or service, leading to social costs or benefits not reflected in market prices.
2. Recognize that when externalities exist, private market outcomes may be inefficient because private incentives do not align with social welfare.
3. Identify government intervention tools to correct externalities, such as taxes (to reduce negative externalities) or subsidies (to encourage positive externalities).
4. Formulate how a tax or subsidy changes the private cost or benefit to reflect the social cost or benefit, effectively internalizing the externality.
5. Conclude that imposing taxes or subsidies aligns private incentives with social costs or benefits, leading to a more efficient market outcome.