Explain the term 'first-best' policy in the context of externalities.

• A. It ensures SMA and MSC equality with minimal cost.
• B. It equals market equilibrium with no externalities.
• C. It imposes maximum taxes to achieve social welfare.
• D. It exactly matches SMB and MSC with no administrative costs or distortions; often theoretical.

Answer: (D)

First-best policy means fully internalizing the externality so the outcome is efficient, with the social marginal benefit exactly equal to the social marginal cost. In this ideal situation there are no administrative costs or distortions, so the policy nudges the market to the efficient quantity—often through a tax per unit equal to the external marginal cost or a corresponding quantity restriction. Real-world policies rarely achieve this perfect benchmark because measurement, enforcement, and other distortions introduce gaps, but it serves as the theoretical standard. The other ideas miss this precise alignment or rely on unrealistic assumptions like no intervention or maximally high taxes.