With a negative externality, what is the relationship between the social optimum and the market equilibrium?

• A. Social optimum occurs at PMB = PMC; Qm = Q*.
• B. Social optimum occurs at SMB = MSC, while market equilibrium occurs at PMB = PMC; Qm > Q*.
• C. Social optimum occurs at PMB = SMB; market equilibrium at MSC = PMC.
• D. Social optimum occurs at PMB = PMC; market equilibrium at SMB = MSC.

Answer: (B)

When there’s a negative externality, the social cost of producing a unit is higher than the private cost borne by the producer. The key idea is to compare the benefit to society with the total cost to society.

The social optimum is found where the social marginal benefit (SMB) equals the social marginal cost (MSC). If there are no external benefits, SMB equals the private marginal benefit (PMB), so the condition becomes PMB = MSC. Since MSC = MPC plus the external cost, this is typically lower than the private-cost-based decision.

The market, on the other hand, takes PMB and private cost (PMC) as given and sets PMB = PMC to determine quantity. It ignores the external cost, so it ends up producing more than is socially desirable. Therefore the market quantity exceeds the social optimum: Qm > Q*.

So the best description is that the social optimum occurs where SMB = MSC, while the market equilibrium occurs where PMB = PMC, leading to overproduction relative to the social optimum.