In a free-market economy, a product that entails a negative externality will be
A. overproduced.
B. underproduced.
C. produced at the optimal level.
D. provided solely by the government.
The correct answer and explanation is:
The correct answer is A. overproduced.
In a free-market economy, products that entail negative externalities tend to be overproduced because the costs of these negative effects are not reflected in the price of the product. Negative externalities occur when the production or consumption of a good imposes costs on third parties who are not involved in the transaction. For instance, when a factory produces goods and releases pollution into the air, the broader community bears the cost of health issues or environmental damage, but the price of the goods produced by the factory does not account for these external costs.
Since producers only consider private costs in their decision-making, they have little incentive to factor in the social costs that their activities impose on others. As a result, they produce more of the good than is socially optimal. In a perfectly competitive market, the price of a product typically reflects the private costs of production, but it does not include the external costs (e.g., pollution, resource depletion, or public health impacts). Therefore, the good is produced in greater quantities than would be desirable from a societal standpoint.
This overproduction occurs because there is no mechanism in the market to internalize the external costs. To correct this issue, governments may intervene through policies like taxes, regulations, or market-based solutions such as tradable permits. These interventions aim to reduce the quantity produced to a more socially optimal level by incorporating the external costs into the price of the product. However, in the absence of such interventions, the market will naturally overproduce goods that have negative externalities.