A factory produces widgets that emit pollution affecting nearby residents' health. The factory's production costs are low, but the health costs to the community are significant and not factored into the price of widgets. What is the most effective way for the government to address this negative externality to achieve a socially optimal level of output?

To address the negative externality caused by the factory's pollution, the government can impose a tax on the factory based on the amount of pollution it produces. This tax would increase the factory's production costs, making it more expensive to produce widgets, which would encourage the factory to reduce its pollution or find cleaner production methods. By making the factory pay for the health costs it imposes on the community, the price of widgets would reflect the true cost of production, leading to a socially optimal level of output. For example, if the tax is set at a level that reflects the health costs, the factory might decide to invest in pollution control technology to lower its tax burden and reduce harm to residents. This way, the government helps balance the needs of the factory with the health and well-being of the community.