The reason externalities distort the allocation of resources is that
A)too few goods are usually produced.
B)firms often go out of business because of the externality.
C)a firm's private costs do not reflect the social cost of production.
D)regulating externalities uses scarce resources.

Question

Quizplus · Accepted Answer

Externalities occur when a firm's production or consumption activities have unintended effects on third parties, either positive (positive externality) or negative (negative externality), that are not reflected in the firm's private costs or benefits. As a result, the firm may produce too much or too little of the good or service relative to what would be optimal from society's perspective. For example, if a factory produces steel and emits pollutants into the air that damage people's health or the environment, the factory's private costs of production do not include the costs of treating illnesses, cleaning up polluted water, or compensating for lost biodiversity. Therefore, the factory may produce more steel than socially desirable, leading to an overallocation of resources to steel production and an underallocation of resources to activities that provide clean air or protect natural habitats. Similarly, if a farmer produces honeybees and pollinates nearby crops, the farmer's private benefits do not include the benefits to the neighboring farmers who get increased crop yields. Therefore, the farmer may produce less honeybees than socially desirable, leading to an underallocation of resources to honeybee production and an overallocation of resources to activities that do not generate positive externalities. By not internalizing the external costs or benefits, the market fails to achieve allocative efficiency, resulting in a welfare loss.

The Reason Externalities Distort the Allocation of Resources Is That