External lead to an overallocation of resources to the specific economic activity. Two possible ways of correcting these spillovers are and.

costs

regulation

taxation

Explanation:

A good has external cost or negative externality if the costs to third parties not involved in production is greater than the benefits. It leads to over allocation of resources to a specific economic activity.

An example of an activity that generates negative externality is pollution. Pollution can be generated at little or no cost, so they are usually overproduced.

Government can discourage the production of activities that generate negative externality by taxation.  Taxation increases the cost of production and therefore discourages overproduction. Tax levied on externality is known as Pigouvian tax.

Government can regulate the amount of externality produced by placing an upper limit on the amount of negative externality permissible

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