Question:
When an externality exists in a free market,
(1) the equilibrium price is determined at an artificially high level.
(2) the equilibrium price is determined at an artificially low level.
(3) market cannot reach equilibrium.
(4) market equilibrium does not ensure socially optimum resource allocation.
(5) the consumers of a product incur extra costs in terms of maintenance and insurance.
Correct Answer:
(4)
Answer Explanation:
Externalities (spillover costs or benefits to third parties) mean that the free market’s private equilibrium (where Marginal Private Cost = Marginal Private Benefit) fails to account for social costs or benefits. Consequently, the market fails to achieve allocative efficiency (the socially optimum resource allocation).
Topic: Market Failure Year: 2020
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