Which of the following is an example of the government promoting market stability in response to externalities?

• A. Imposing taxes on firms that pollute to internalize negative externalities
• B. Allowing firms to set their own pollution standards without regulation
• C. Ignoring the presence of externalities in the market
• D. Subsidizing monopolies to increase their market power

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the concept of externalities. Externalities occur when a third party is affected by the actions of others, and these effects are not reflected in market prices. Negative externalities, such as pollution, impose costs on society that are not borne by the producer.
2. Step 2: Recognize the role of government in promoting market stability. When negative externalities exist, markets may fail to allocate resources efficiently. The government can intervene to correct this market failure and promote stability.
3. Step 3: Identify common government interventions for negative externalities. These include imposing taxes on firms that generate negative externalities (Pigovian taxes), setting regulations or limits on harmful activities, or providing subsidies to encourage positive externalities.
4. Step 4: Analyze the options given. Imposing taxes on firms that pollute is a way to internalize the external cost, making firms pay for the social cost of pollution, which aligns private costs with social costs and promotes market stability.
5. Step 5: Conclude that the correct example of government promoting market stability in response to externalities is imposing taxes on polluting firms, as it directly addresses the negative externality and encourages firms to reduce pollution.