When external costs are present in a market:
A) market prices are still able to send the correct signals.
B) market prices send incorrect signals.
C) social surplus is maximized.
D) consumer surplus is not maximized.

Question

Quizplus · Accepted Answer

External costs create a divergence between private costs and social costs. Market prices only account for private costs, and therefore do not reflect the true cost of production or consumption. This results in an overproduction or overconsumption of goods, leading to suboptimal outcomes. Thus, market prices send incorrect signals when external costs are present in a market.

When External Costs Are Present in a Market