Explain externality, how can government intervene to achieve allocative efficiency in case of external cost or external benefit?

Answer

The term externalities refers to both external economies and diseconomies. When the action of an economic decision maker creates benefits for others, without being compensated it creates an external economy for others. When the action of an individual creates costs for others for which he does not pay, it creates an external diseconomy.

Government can intervene to achieve allocative efficiency by the following ways-

1) Imposing taxes.

2) Providing subsidies.

3) Setting quotas limits.