What is the main purpose of government intervention in markets with externalities?

• A. to internalize external costs and benefits
• B. to maximize firm profits
• C. to standardize prices
• D. to eliminate all trade

Answer: (A)

Externalities create a mismatch between private incentives and social welfare because costs or benefits spill over to others and aren’t reflected in market prices. This leads to overproduction when costs spill over (negative externalities) and underproduction when benefits spill over (positive externalities). Government intervention aims to internalize these spillovers, bringing private decisions in line with social costs and benefits. It can tax activities that impose costs on others, subsidize activities with social benefits, regulate or set standards to limit harmful effects, or provide goods and services directly when markets underprovide them. By internalizing, the quantity moves toward the socially optimal level where social marginal cost equals social marginal benefit, reducing deadweight loss and increasing overall welfare. The other options don’t address these spillovers and thus don’t improve welfare in markets with externalities.