1. that the economy must necessarily operate inefficiently with respect to the production of the product in question.
2. that the quantity produced of the product in question, despite what the government does, cannot be the socially optimal quantity.
3. that private costs and benefits are not everywhere equal to social costs and benefits.
4. that all of the above are true.
Choose the option that yields the correct answer.
Option 3 is the correct one. The term externality means that there are costs or benefits from an activity that are external to the individuals making the decision whether or not to engage in it---that is, there is a divergence between private costs or benefits and social costs or benefits. If there is no government intervention, the result will be inefficient operation of the economy as reflected in the production and consumption of a non-optimal output of the commodity in question. If there is appropriate intervention by the government, however, the inefficiencies resulting from the externality can often be eliminated. By appropriate taxes and/or subsidies, the government may be able to induce people to produce and consume the socially efficient output despite the externality.