How do taxes or subsidies correct externalities?

Taxes and subsidies correct externalities by altering market prices to reflect the true social cost or benefit of a good or service.

Externalities are costs or benefits that affect parties not directly involved in a transaction. They can be either positive (benefits) or negative (costs). When externalities exist, the market fails to allocate resources efficiently, leading to a situation where social welfare is not maximised. This is where government intervention, in the form of taxes and subsidies, comes into play.

Taxes are used to correct negative externalities. A negative externality, such as pollution from a factory, imposes a cost on society that is not reflected in the market price of the good or service produced. By imposing a tax on the producer, the government can make the producer 'internalise' this external cost. The tax increases the cost of production, which in turn increases the market price. This higher price discourages consumption and brings it closer to the socially optimal level. In essence, the tax serves to make the market price reflect the true social cost of the good or service.

On the other hand, subsidies are used to correct positive externalities. A positive externality, such as the benefits of education, provides a benefit to society that is not reflected in the market price. By providing a subsidy to consumers or producers, the government can lower the market price and encourage more consumption or production. This brings the quantity of the good or service closer to the socially optimal level. The subsidy serves to make the market price reflect the true social benefit of the good or service.

In both cases, taxes and subsidies are used as tools to correct the market failure caused by externalities. They alter market prices to reflect the true social cost or benefit, leading to a more efficient allocation of resources. However, it's important to note that the effectiveness of these interventions depends on the accuracy of the government's assessment of the externality and the responsiveness of consumers and producers to price changes.