Provide an example where negative externality with high transaction costs leads to government intervention.

• A. Air pollution from a factory with diffuse impacts; negotiating is costly; hence regulation or taxes.
• B. A neighbor playing loud music.
• C. A company reducing emissions voluntarily.
• D. A consumer buying more than needed.

Answer: (A)

High transaction costs in bargaining over a negative externality can justify government intervention. When pollution comes from a factory and affects many people in a diffuse way, negotiating with each affected party would be prohibitively expensive and time-consuming. Because those costs prevent a bargaining solution from emerging, the market fails to internalize the social cost of pollution. Government action—such as a Pigouvian tax that charges polluters for each unit of pollution or direct emission standards—helps internalize those external costs and nudges the outcome toward the socially optimal level of production.

The given example fits this idea: pollution from a factory with diffuse impacts creates a situation where private negotiation is costly, making regulation or taxes the sensible response to align private incentives with social well-being. The other scenarios don’t illustrate high-cost bargaining over a broad external effect: a neighbor playing loud music is typically a private nuisance and can often be resolved through direct negotiation or legal action; a company reducing emissions voluntarily represents a private, non-governmental response; a consumer buying more than needed isn’t an externality issue.