Introduction: It is observed that under perfect competition, an economy's scarce resources are optimally allocated and social welfare is maximized. This situation of perfect competition can prevail only if all the costs of production are accounted for in the price of the product. However, certain production costs are not included in the price of the product. This gives rise to externalities that result in market failure.
Task: Explain the reasons for under-allocation of the economy's scarce resources in case of benefit externalities, and their over-allocation in the case of cost externalities. Do you think that government intervention is necessary to eliminate the effects of externalities?
Arrange your answer as per the following guidelines:
Describe benefit and cost externalities.
List the reasons for lack of optimal allocation of resources in each case.
Explain the need for government intervention in case of market failure due to externalities.
Explain why government intervention may not be needed in certain cases with the help of the 'Coase Theorem.'