Question

Show why externalities can lead competitive markets to provide socially inefficient quantities of goods and services; explain how government policies, such as the Clean Air Act, can improve resource allocation.

Short answer

Negative externalities can increase both internal and external costs to be borne both by industries and by the entities who are suffering, resulting in market failure. The imposition of the Clean Air Act would eventually reduce the external cost borne by the entities, thus bringing public welfare.

Step-by-step solution

Negative Externality

It is caused when a firm’s production process threatens the economy or the economic entities. Such might result in the bearing of both internal and external costs, thus leading to inefficient allocation of resources, causing market failure. For example, a pipe manufacturer has three chimneys through which high toxic gases are diffused into the air, which causes air pollution, resulting in external costs borne by the people nearby to reduce the impact of such toxic gases.

One can show the market failure in the below diagram:

The figure shows that due to internal and external costs, there is a reduction of output and an increase in price borne by the firm resulting in the shift of resources from the equilibrium, thus causing inefficiency and, in turn, market failure.

Clean Air Act

The Act thus imposed by the government covers all industries producing more than 10 tons of pollutants. These acts generally indicate the process where the industries have to buy permits to pollute the environment. Moreover, this Act also includes regulating pollutants through proper installations of such inputs that reduce the pollution, which is also to be checked within a regular interval of time. Moreover, such an act, in turn, had posed an increased cost on both fixed and variable terms which in turn reduces the output of the firm.

From the diagram above, one can understand that the enactment of such policies decreased the firms' production and increased the price of the products. However, it has successfully decreased pollution, thus improving public welfare. Moreover, the firms being able to sell the permits to other firms can induce them to innovate to provide a less pollution strategy to reduce the pollution caused by the firm.

Thus, we can conclude that enacting such an act brought proper resource allocation to the economy.