Question

Externalities distort _____ by not reflecting the true costs and benefits of producing a good or service.

A. taxes

B. price signals

C. regulations

Answer 1

B.

Externalities are present when production is not efficient, therefore the firm will overproduce when they only take into account their private costs, and as a result, the price will be lower. Therefore the price signals are distorted.

Answer 2

Externalities are defined as the spillover effects of the consumption or production of a good that is not reflected in the price of the good.

Externalities distort price signals by not reflecting the true costs and benefits of producing a good or service. Correct answer: B

Example: Electricty production from fossil fuels results in pollution being released into the air, but the cost of the pollution to the environment is not reflected in the price of electricity.