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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 correctly describes the market outcome?

Social cost exceeds private cost because the downstream communities bear uncompensated harm. The plant ignores this cost and so produces more than the socially optimal output. This is a negative production externality that leads to overproduction relative to the efficient level.

  1. APrivate cost exceeds social cost, so the plant produces too little
  2. BSocial cost exceeds private cost, so the plant produces more than the socially optimal outputCorrect
  3. CSocial benefit exceeds private benefit, so output is too low
  4. DPrivate and social costs are equal, so output is efficient
  5. The market is a public good and will not be supplied

Explanation

The fishing communities bear a cost that the plant ignores. Marginal social cost is therefore above marginal private cost. The firm sets output where private marginal cost equals price, which is beyond the point where social marginal cost equals marginal benefit, so output is excessive.

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