What condition defines the social optimum in presence of externalities?

• A. Private marginal benefit equals private marginal cost.
• B. External costs equal external benefits.
• C. Externalities have no effect on optimum.
• D. Social marginal benefit equals social marginal cost.

Answer: (D)

When externalities are present, the socially best outcome occurs where the social marginal benefit equals the social marginal cost. Social marginal benefit is the private marginal benefit plus any external benefit to others, while social marginal cost is the private marginal cost plus any external cost imposed on others. If the social marginal benefit exceeds the social marginal cost, increasing the quantity increases overall welfare, so output should rise; if the social marginal cost exceeds the social marginal benefit, output should fall. Setting them equal identifies the social optimum. The private condition (private MB = private MC) ignores external effects, while the other statements misstate how externalities influence efficiency.