What are the ways of correcting market failure?

[Asfaw Tasew]

how taxation is used as a market failure correction tool?

[asfo]

An example of a way that taxation can be used to correct market failure, is in a case where there is a negative externality.

On the production side, when the social marginal cost of production exceeds private marginal cost (eg. additional social costs of pollution), producers who do not take into account the additional social cost will produce a quantity of output that is greater than the socially optimal quantity. Government can correct this market failure by taxing producers by an amount equal to the difference between the private marginal cost and social marginal cost. This makes producers take the social cost into account, and cause them to reduce their output to the socially optimal amount. This is known as 'internalising the externality'.

Taxation can also correct negative externalities on the consumption side. For example, consuming cigarettes may have a social marginal benefit that is lower than the private marginal benefit, if consumers do not take into account the effects of second-hand smoke on the health of others. This would mean that consumers would consume too much of the good compared to the socially optimal quantity. Government can tax consumption of the good in a way that makes consumers fully 'internalise the externality'. Since the tax makes the good cost more, consumers will reduce their consumption of the good, to the socially optimal quantity, and thus, the market failure would be corrected.

Some links with basic info about externalities:
http://tutor2u.net/economics/content/top...lities.htm
http://tutor2u.net/economics/content/top...lities.htm