Question

When negative externalities exist, how do free markets misallocate resources?

Answer 1

A negative externality gives rise to an externality cost, which is ignored by firms in absence of government intervention. When this cost is internalized, marginal social cost is higher than marginal private cost, therefore supply falls, increasing price and decreasing quantity. But in free market, this external cost is not internalized. Therefore firms supply more than the socially efficient quantity. As a result, price is lower and quantity is higher in free market, compared to socially efficient price and quantity.