How can government regulation addressing externalities affect a producer's output decisions?

• A. Regulation always increases a producer's output regardless of externalities.
• B. By internalizing external costs, regulation can lead producers to reduce output to the socially optimal level.
• C. Regulation only affects consumer choices, not producer output decisions.
• D. Regulation has no impact on a producer's output decisions when externalities are present.

Answer: (B)

Verified step by step guidance

1. Step 1: Understand what an externality is — it occurs when a producer's or consumer's actions impose costs or benefits on others that are not reflected in market prices. For example, pollution is a negative externality because it harms others but is not paid for by the producer.
2. Step 2: Recognize that without regulation, producers typically ignore external costs, leading to overproduction compared to the socially optimal level. This is because their private cost is lower than the true social cost.
3. Step 3: Learn that government regulation aims to internalize these external costs, meaning it forces producers to take these costs into account, often through taxes, permits, or standards.
4. Step 4: When external costs are internalized, the producer's cost curve shifts upward to reflect the true social cost. This change influences the producer's output decision, typically causing a reduction in output to the socially optimal level where marginal social cost equals marginal benefit.
5. Step 5: Conclude that regulation affects producer output decisions by aligning private incentives with social welfare, leading to a decrease in output when negative externalities are present, contrary to the idea that regulation always increases output or has no effect.