Answer to Question #46608 in Economics of Enterprise for Rahul Kumar

Question

What do you understand by the term ‘externalities’? Explain the various methods to deal with
externalities.

Answer 1

Externality is a consequence of an economic activity that is experienced by unrelated third parties. An externality can be either positive or negative. The people will be better off if positive externalities are promoted and negative externalities are reduced. Since private parties cannot profit from externalities, governments must use laws and taxes to achieve these goals. Governments have several methods to reduce the effects of negative externalities and to promote positive externalities. Government intervention can generally be divided into 2 types of actions: command-and-control policies that regulate actions directly and market-based policies that would provide incentives so that the self-interest of the market participants would achieve the socially optimized solution.