Which of the following economic situations would result in over-allocation of resources to the production of a good?
a good with external benefits
a good with external costs
a good with a free-rider problem
The answer to this is “goods with external costs.” These external costs are also called “negative externalities.”
When there is a negative externality, there are costs to the production of a good that are not reflected in the price that consumers must pay for it. For example, if a company pollutes while making a good, the cost of cleaning up the pollution is typically not included in the price of that good. The price of cleaning up goes to the taxpayers, not to those who buy the good. In such a case, the price of the good will be lower than it should be. More people will buy the good than would buy it at its “true” price. This leads to an over-allocation of resources to the production of that good.