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

Which government response to a negative externality works by making the polluting firm face the full social cost of its output, without dictating the specific method of reducing emissions?

A Pigouvian tax set equal to the marginal external cost. It internalises the externality by raising the firm's private cost to the social cost, so the firm chooses its own cheapest way to cut output or emissions.

  1. AA Pigouvian tax set equal to the marginal external cost at the optimal outputCorrect
  2. BA legal ban on all output of the good
  3. CA subsidy paid to consumers of the good
  4. DA price ceiling below the market price
  5. Nationalisation of all firms in the industry

Explanation

A Pigouvian tax equal to marginal external cost internalises the externality, letting the firm choose how to cut emissions. A ban removes output entirely and is not efficient. A consumer subsidy raises demand and worsens the problem. A ceiling does not address the externality.

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