Final answer:
Subsidies encourage activities with external benefits, while taxes are applied to discourage activities with external costs. The correct option to the question is C) subsidies are used to overcome external benefits, and taxes to overcome external costs.
Step-by-step explanation:
To address the student question, it's important to understand how government subsidies and taxes interact with external costs and benefits. An external cost or negative externality occurs when a firm's production imposes costs on third parties that are not reflected in the market price of goods or services. Think of pollution as an example. On the other hand, an external benefit or positive externality exists when a firm's actions lead to benefits for third parties, like education or vaccinations, which contribute to societal well-being.
To increase efficiency, policymakers use subsidies to encourage actions that have external benefits. For example, by subsidizing education through grants or lower tuition costs, more individuals may invest in their education, thus generating societal benefits beyond their personal gains. Conversely, taxes are applied to activities with external costs to discourage production or consumption of those goods or services. By imposing a tax on pollution, for instance, the government can reduce the negative impact on the environment.
Therefore, when it comes to overcoming externalities to increase efficiency, the answer to the student's question is that subsidies are used to overcome external benefits by encouraging more of the beneficial activity, and taxes are used to overcome external costs by discouraging the costly activity. The correct option is C) subsidies are used to overcome external benefits, and taxes to overcome external costs. Mentioning this correct option answer in the final answer helps in providing clarity.