Give an example of a negative externality and suggest a policy instrument to address it.

• A. Pollution from a factory; implement a per-unit tax or cap-and-trade.
• B. Vaccination; impose a tax on vaccines.
• C. Education; require more fees.
• D. Traffic congestion; build toll roads to reduce consumption.

Answer: (A)

The main idea here is that a negative externality is a cost of production or consumption that falls on others and isn’t reflected in the market price. Pollution from a factory is the classic case: the factory’s emissions create health and environmental costs for people nearby that investors and workers don’t pay for in the market price.

A per-unit tax on pollution (a Pigouvian tax) or a cap-and-trade system addresses that by making the polluting activity pay for the social cost it imposes. The tax raises the private cost of emitting to align it with the true social cost, encouraging firms to reduce emissions or adopt cleaner technologies. Cap-and-trade sets a total pollution limit and allows firms to buy and sell permits, achieving emissions reductions where they’re cheapest. Both options internalize the external cost, improving efficiency and reducing the overall harm.

Vaccination and education involve positive externalities, so taxing vaccines or charging more fees would discourage activities that generate social benefits. Traffic congestion is a negative externality too, and tolls can work, but the pollution example paired with a well-known corrective tool is the clearest match for explaining how to fix negative externalities.