Which of the following statements best describes the efficiency of producing a good in the presence of externalities?

• A. Production is efficient as long as the external benefits exceed the external costs.
• B. Production is efficient whenever private benefits exceed private costs.
• C. Production is always efficient regardless of externalities.
• D. Production is efficient only if the social benefits exceed the social costs.

Answer: (D)

Verified step by step guidance

1. Step 1: Understand the concept of externalities. Externalities occur when the production or consumption of a good affects third parties who are not directly involved in the transaction. These effects can be either positive (external benefits) or negative (external costs).
2. Step 2: Define private costs and private benefits. Private costs are the costs borne by the producer, and private benefits are the benefits received by the producer or consumer directly involved in the market transaction.
3. Step 3: Define social costs and social benefits. Social costs include both private costs and any external costs imposed on others, while social benefits include private benefits plus any external benefits to others.
4. Step 4: Recognize that efficiency in production requires considering the full impact on society, not just private costs and benefits. This means production is efficient only if the total social benefits exceed the total social costs.
5. Step 5: Conclude that statements focusing only on private costs and benefits or ignoring externalities do not capture the true efficiency condition. The correct efficiency criterion involves comparing social benefits and social costs.