Which policy instrument is typically used to internalize a negative externality?

• A. Price ceilings
• B. Taxes to internalize externalities
• C. Subsidies to producers
• D. Quotas

Answer: (B)

Internalizing a negative externality means making the private costs faced by producers or consumers reflect the true social costs of their actions. A tax per unit, known as a Pigouvian tax, achieves this by increasing the private cost of production or consumption by exactly the measure of the external damage per unit. When the price rises to reflect the social cost, quantity falls toward the socially optimal level, and the tax revenue can be used to offset or remedy the damage.

Other options don’t achieve this adjustment as effectively: price controls like price ceilings distort the market and don’t incorporate the external harm into the price; quotas restrict quantity but don’t attach a per-unit external cost; subsidies encourage more production, which can worsen the externality.