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IAI Actuarial Core Principles · Business Economics · Relationship between the government and the individual firm

A cement plant in Gujarat releases dust that damages crops on neighbouring farms, and the plant pays nothing for this damage. Which statement best describes the resulting market outcome?

With a negative externality, the dust damage is not borne by the plant, so its private cost is below the social cost. The firm therefore over-produces relative to the socially efficient output, and the market allocates too many resources to cement.

  1. AThe plant's private cost is below the social cost, so output is higher than the socially efficient levelCorrect
  2. BThe plant's private cost exceeds the social cost, so output is lower than the socially efficient level
  3. CPrivate and social costs are equal, so the outcome is efficient
  4. DThe market is efficient because the farmers can simply move away
  5. The damage is a public good, so the government must supply it

Explanation

A negative production externality means the plant ignores the cost imposed on farmers. Marginal social cost is therefore above marginal private cost. The firm produces where private marginal cost equals price, which is more than the socially optimal output.

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