Final answer:
The presence of negative externalities in production, like pollution, means the firm's internal costs (Option 4)understate the true social and environmental costs. This underestimation leads to market failure and overproduction, contributing to greater negative externalities.
Step-by-step explanation:
In the case of negative externalities in production, such as pollution, the firm's internal costs understate the true cost of producing the product. This is because the internal costs borne by the firm do not include the additional social and environmental costs that are incurred by third parties outside the production process. When these external costs, such as the cost of pollution, are taken into account, they reveal that the social costs of production are in fact higher than what is reflected in the firm's internal costs.
Therefore, the correct answer to the student question is that in the presence of negative externalities in production, the firm's internal costs understate the true cost of producing the product. This underestimation can lead to a situation of market failure, where the price mechanism fails to account for all social costs and benefits, resulting in overproduction of the product that generates negative externalities.