Final answer:
The best response to externalities should account for the market failure that occurs when negative externalities like pollution are present, causing social costs to exceed the benefits and leading to overproduction. The social cost curve is above the market supply curve due to firms not accounting for these costs.
Step-by-step explanation:
Factors to consider when figuring out the best response to externalities include the ways in which the presence of externalities affects market equilibrium. Externalities, such as pollution, cause the supply curve to no longer represent all social costs. This is due to firms not accounting for the external costs they impose on society, such as environmental damage. The result is a form of market failure, where the market output leads to social costs of production exceeding the social benefits to consumers, causing overproduction of the product. This misalignment between private and social costs is common in negative externalities.
The true social cost, including these externalities, is above the supply curve because the market fails to incorporate these extra costs into production decisions. This is depicted by a shift upwards of the supply curve if firms were forced to pay for these external costs. Therefore, when considering Coase's Theorem and the best response to externalities, option (d) is correct: The social cost is above the supply curve due to the presence of negative externalities.