Question

How is the socially optimal or efficient level of output determined?

Also,

why do markets overprice or underprice when externalities are present?

Answer 1

The socially optimal or efficient level of output is determined at the point at which the social cost curve intersects the social benefits curve.

Market price is determined on the basis of private costs and private benefits. The market does not take external costs or benefits into account. Therefore, when the price is determined in the market on the basis of private costs and private benefits, overpricing takes place in the case of positive externalities and underpricing takes place in the case of negative externalities.