If the MSC curve lies above the MPC curve and the MSB meets these curves at the market equilibrium, what does this indicate about the externality?

• A. The production creates a negative externality
• B. The production creates a positive externality
• C. There is no externality
• D. The market is perfectly efficient

Answer: (A)

Externalities exist when the social impact of production differs from what the market private costs imply. If the marginal social cost is higher than the marginal private cost, the production imposes additional costs on society that producers don’t bear. This means the market quantity is too high relative to the social optimum because prices and quantities in an unregulated market reflect private costs, not these extra social costs. When the socially measured benefits and costs line up with the market outcome in this way, it signals that the external costs aren’t internalized, which is a negative externality in production. In such cases, society would be better off producing less, and policies like taxes or regulations can help internalize those costs so the private decision aligns with the social optimum.