Which statement about externalities and social efficiency is true?

Which statement about externalities and social efficiency is true?

• A. Negative externalities reduce social welfare; positive externalities increase social welfare but markets underprovide them.
• B. Negative externalities increase social welfare; positive externalities reduce social welfare.
• C. Externalities have no effect on social efficiency.
• D. Positive externalities always lead to overproduction.

Answer: (A)

Externalities create a gap between private incentives and social welfare, so social efficiency happens where the social marginal cost equals the social marginal benefit. Negative externalities push the private decision maker to produce too much because they don’t bear all the costs imposed on others, lowering overall welfare and causing a deadweight loss. A common example is pollution: a factory emits pollution that harms nearby residents, but the factory ignores those costs. Policy tools like taxes or regulations can raise the private cost to align with the social cost, helping production move toward the social optimum. Positive externalities occur when the total benefit to society exceeds the private benefit captured by the chooser, so the market underproduces the activity. Vaccination, environmental benefits, or spillovers from research are classic cases where society gains more than the individual buyer gets. Because the market underprovides these benefits, social welfare would rise if more of the activity took place, which explains why subsidies or public provision can raise output toward the socially efficient level. Thus, negative externalities reduce social welfare and positive externalities raise it, but markets tend to underprovide the latter, not overprovide them. The other statements contradict these ideas about how externalities affect welfare and production.

Externalities create a gap between private incentives and social welfare, so social efficiency happens where the social marginal cost equals the social marginal benefit. Negative externalities push the private decision maker to produce too much because they don’t bear all the costs imposed on others, lowering overall welfare and causing a deadweight loss. A common example is pollution: a factory emits pollution that harms nearby residents, but the factory ignores those costs. Policy tools like taxes or regulations can raise the private cost to align with the social cost, helping production move toward the social optimum.

Positive externalities occur when the total benefit to society exceeds the private benefit captured by the chooser, so the market underproduces the activity. Vaccination, environmental benefits, or spillovers from research are classic cases where society gains more than the individual buyer gets. Because the market underprovides these benefits, social welfare would rise if more of the activity took place, which explains why subsidies or public provision can raise output toward the socially efficient level.

Thus, negative externalities reduce social welfare and positive externalities raise it, but markets tend to underprovide the latter, not overprovide them. The other statements contradict these ideas about how externalities affect welfare and production.