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IAI Actuarial Core Principles · Business Economics · Government intervention in a market

A chemical plant in Gujarat discharges effluent into a river, harming downstream fishing communities who receive no compensation. The plant's private costs are lower than the total cost to society. Which description best explains why government intervention may be justified?

The plant imposes uncompensated costs on others, which is a negative externality. Since private cost is below social cost, the market produces more than the socially optimal quantity, and this overproduction is the market failure that can justify government intervention such as taxes or regulation.

  1. AA negative externality leads to overproduction relative to the social optimumCorrect
  2. BA positive externality leads to underproduction relative to the social optimum
  3. CA public good is being provided at too high a price
  4. DInformation asymmetry is causing adverse selection in the market
  5. The plant holds a natural monopoly over the river

Explanation

Because the plant ignores the cost imposed on fishing communities, its marginal private cost is below marginal social cost. Output therefore exceeds the socially efficient level. This is a negative externality, a classic market failure justifying taxes, regulation or tradable permits. Option B has the sign reversed.

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