How does the presence of externalities affect the efficiency of a competitive market?

• A. It reduces efficiency; DWL arises because quantity is not at the social optimum.
• B. It increases efficiency.
• C. It has no effect.
• D. It always breaks market equilibrium.

Answer: (A)

Externalities occur when the consequences of a market transaction affect people who are not involved in the transaction. In a competitive market, prices and quantities are determined by private costs and benefits, ignoring these external effects. When there is a negative externality, the social cost of production is higher than the private cost, so the socially optimal quantity is smaller than the market quantity. The market overproduces relative to this social optimum, and the surplus that could have been enjoyed if production reflected social costs is lost, creating deadweight loss. If the externality is positive, the market underproduces relative to the social optimum, again generating deadweight loss. In either case, the presence of externalities means the market fails to maximize social welfare, so efficiency falls. The equilibrium still exists, but it’s at an output level that is not socially optimal.