Production that harms third parties

An external cost is a cost of production that falls on someone who is not part of the sale, such as pollution from a factory affecting nearby residents. Firms base their supply decisions on their own private costs, so the market supply curve reflects marginal private cost only. Marginal social cost adds the external cost on top: MSC = MPC + marginal external cost. So the MSC curve sits above the supply curve. The market settles where demand meets the lower supply curve, at a larger quantity than the socially optimal one where demand (marginal social benefit) meets MSC. The units in between cost society more than they are worth to buyers, which creates deadweight loss. Left alone, the competitive market produces too much of the good.

Each choice

• A. The position is reversed. Social cost includes private cost plus the external cost, so MSC sits above market supply, not below it.
• B. A subsidy encourages even more production of a good that is already overproduced. The usual fix for an external cost is a per-unit tax equal to the external cost, which shifts supply up toward MSC.
• C. Firms still profit from selling the good, so the market produces it, just too much of it. Markets that fail to provide a good at all are the public goods case.
• D (correct). An external cost that sellers do not pay makes the market produce too much.
• E. Market price still clears the market where supply meets demand. Externalities cause the wrong quantity, not a lasting gap between quantity supplied and quantity demanded.