In the presence of a negative externality, if external costs are not internalized, the market tends to produce too much, causing:

• A. Underproduction
• B. Overproduction
• C. Efficient production
• D. No change to output

Answer: (B)

When a negative externality exists, the costs imposed on others are not felt by the producer. If those external costs are not internalized, firms only consider their private costs and ignore the additional social costs. This means the true cost to society is higher than the cost reflected in the market price, so producers will expand output until private marginal cost equals price. However, the socially optimal level of output occurs where the social marginal cost (private cost plus external cost) equals the social marginal benefit, which is at a lower quantity. So the market ends up producing more than is socially desirable, leading to overproduction and a welfare loss to third parties. Internalizing the external costs—through taxes, regulations, or similar measures—shifts the perceived cost upward, reducing production toward the efficient level.