To reduce the size of a negative externality, what must happen to the price of the good?

• A. The new price must be lower than the price in equilibrium
• B. The price must be unchanged
• C. The new price must be higher than the price in equilibrium
• D. The price must be unrelated to equilibrium

Answer: (C)

When a negative externality exists, the market price doesn’t reflect the full social cost, so too much of the good is produced and consumed. To reduce the externality, you need to discourage production and consumption by making buyers pay more per unit. Raising the price above the equilibrium price lowers the quantity toward the social optimum, where marginal social cost equals marginal benefit. A lower price would increase quantity and worsen the externality; keeping the price the same leaves the external cost unaddressed; a price unrelated to equilibrium wouldn’t guide choices toward the socially optimal outcome.