Question

Why don't private solutions to externalities always work?

a) Private solutions are always more efficient.
b) Private solutions rely on the Coase theorem.
c) Private solutions may face transaction costs and information asymmetry.
d) Private solutions are guaranteed to address externalities.

Answer 1

Private solutions to externalities may not always work due to transaction costs and information asymmetry. Government intervention may be needed to achieve a more socially optimal outcome.

Step-by-step explanation:

In economics, externalities refer to the costs or benefits that are not reflected in the prices of goods or services. Private solutions to externalities may not always work because of transaction costs and information asymmetry.

Transaction costs, such as the cost of negotiating and enforcing agreements, can make it difficult for parties to reach a mutually beneficial solution. Information asymmetry, where one party has more information than the other, can also prevent private solutions from effectively addressing externalities.

For example, consider a factory that emits pollutants into the air. The pollution imposes costs on nearby residents in the form of health problems and reduced quality of life. In a private solution, the factory and the affected residents could negotiate a compensation agreement to address the external costs. However, the residents may not have access to the full information about the health risks or the true cost of reducing pollution, which can hinder their ability to negotiate a fair agreement.