If a negative externality exists, an unregulated firm tends to produce more than the social optimum and charge a price that is

• A. greater than the social optimum; price is too high
• B. greater than the social optimum; price is too low
• C. less than the social optimum; price is too high
• D. equal to the social optimum; price reflects social costs

Answer: (B)

When there’s a negative externality, the social cost of producing a good is higher than the private cost faced by the firm. The firm ignores those extra costs, so it tends to produce more than what’s socially optimal. The price the firm charges is based on its private marginal cost, not the higher social cost. That makes the price too low relative to the value society places on the good once external costs are counted. So you get too much output and a price that doesn’t reflect the full social cost—the price is too low and quantity is too high compared to the social optimum.