In a market with a negative externality, is the market quantity higher or lower than the socially optimal quantity?

In a market with a negative externality, is the market quantity higher or lower than the socially optimal quantity?

• A. Market quantity is lower than socially optimal.
• B. Cannot be determined.
• C. Market quantity is higher than socially optimal; external costs are not reflected in price, leading to overproduction.
• D. Market quantity equals socially optimal.

Answer: (C)

With a negative externality, the costs imposed on others are not reflected in the market price. The private cost to producers is lower than the true social cost, so the social cost curve sits above the private cost curve. The market sets quantity where price equals private marginal cost, while the socially optimal quantity is where price equals marginal social cost. Since marginal social cost is higher, the quantity that balances marginal benefit with marginal private cost is larger than the quantity that balances marginal benefit with marginal social cost. In short, the market produces too much because external costs aren’t reflected in price, leading to overproduction.

With a negative externality, the costs imposed on others are not reflected in the market price. The private cost to producers is lower than the true social cost, so the social cost curve sits above the private cost curve. The market sets quantity where price equals private marginal cost, while the socially optimal quantity is where price equals marginal social cost. Since marginal social cost is higher, the quantity that balances marginal benefit with marginal private cost is larger than the quantity that balances marginal benefit with marginal social cost. In short, the market produces too much because external costs aren’t reflected in price, leading to overproduction.