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

• A. Foreign investment always ensures that social benefits are greater than social costs, leading to optimal resource allocation.
• B. Foreign investment has no impact on the social costs or benefits in a transitioning economy.
• C. Foreign investment eliminates all market failures by internalizing externalities.
• D. Foreign investment can lead to negative externalities such as environmental degradation, where social costs exceed private costs.

Answer: (D)

Verified step by step guidance

1. Step 1: Understand the concept of externalities in microeconomics. Externalities occur when a third party is affected by the production or consumption of a good or service, and these effects are not reflected in market prices.
2. Step 2: Recognize that foreign investment can influence both social benefits and social costs in a transitioning economy. Social benefits include private benefits plus any positive externalities, while social costs include private costs plus any negative externalities.
3. Step 3: Analyze how foreign investment might create negative externalities, such as environmental degradation, where the social costs (private costs plus external costs) exceed the private costs borne by investors.
4. Step 4: Understand that when social costs exceed private costs, the market outcome is inefficient because the external costs are not internalized, leading to overinvestment or overproduction from a social perspective.
5. Step 5: Conclude that foreign investment can be problematic in transitioning economies if it leads to negative externalities, causing a divergence between private incentives and social welfare, which may require government intervention to correct.