How do you compute social welfare in markets with externalities?

• A. Social welfare equals consumer surplus plus producer surplus.
• B. Social welfare equals consumer surplus plus producer surplus plus government revenue minus external costs.
• C. Social welfare equals consumer surplus plus producer surplus plus government revenue minus external costs plus external benefits; measure SMB vs MSC.
• D. Social welfare equals government revenue only.

Answer: (C)

When externalities exist, private measures like consumer surplus and producer surplus miss part of the value or cost that society bears. To capture total welfare, you add the net value from external effects to the usual surpluses. That net external value can be positive (external benefits) or negative (external costs). So social welfare is CS plus PS plus the net externalities. If the government intervenes, its revenue can also contribute to welfare by financing public goods or reducing distortions, so you include government revenue in the tally. Framing this with SMB (social marginal benefit) versus MSC (social marginal cost) makes the logic precise: welfare from producing an extra unit is the incremental social benefit minus the incremental social cost. The combination CS + PS + government revenue - external costs + external benefits captures both the private surpluses and the full net social impact of externalities, aligned with the SMB vs MSC perspective. The other options leave out external benefits, ignore external costs, or omit the role of government revenue, which is why they don’t fully account for social welfare in the presence of externalities.