Economics

Suppose that there is a negative externality in the market. In this situation, the marginal social cost curve lies above the marginal private cost curve. In short, marginal private cost of producing, say good X, is less than the marginal social cost. The firm produces at the point where MR  MC. The production of X, however, has negative effects on the production of other goods. As such, the social cost curve lies above the private cost.

Now, in order to restore efficiency, MSC (marginal social cost) must be equal to MB (marginal benefit). The government may impose an externality tax against the producer of X. Imposing an externality tax induces the firm to reduce the output of X to the point where MSC  MB. Suppose that government intervention is absent. The other firms affected by the production of X may compensate the firm to reduce output to the point where MSC  MB.

Suppose that there is positive externality. In this situation, the social demand curve lies above the private demand curve. In short, there is a need to produce, say, good Y to accommodate the excess demand (such goods are termed public goods). Now, the government can compensate the producer of Y to increase output to the point where MB  SD. At this point, efficiency is restored.

Suppose that there is price differentiation between two similar goods. The marginal utility derived the consumption of A varies from individual to individual, as prices vary. Information dissemination is necessary to correct the distortion. Suppose that one market is distorted while the associative (similar) other market is efficient. Now, the second best solution is to distort the efficient market to restore efficiency in the other market. For example, the policy maker may opt to increase demand in one market to reduce demand in another market.