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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. Which statement best describes the market outcome in the absence of intervention?

Output is above the socially optimal level, because the plant ignores the external pollution cost, so its private marginal cost is lower than the social marginal cost. The market overproduces and an intervention such as a tax is justified.

  1. AOutput is below the socially optimal level because the plant's private costs exceed social costs
  2. BOutput is above the socially optimal level because the plant's private costs are lower than the social costsCorrect
  3. COutput is at the socially optimal level because the plant maximises profit
  4. DOutput is below the socially optimal level because social benefits exceed private benefits
  5. Output is above the socially optimal level because the plant's private benefits exceed social benefits

Explanation

Pollution is a negative production externality. The firm ignores the external cost borne by fishers, so private marginal cost is below social marginal cost. The market therefore overproduces relative to the social optimum. Options describing private costs above social costs reverse the relationship.

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