A picture of market failures and explain it

Expert Solution

A market failure occurs when there is a negative externality which means that actions taken by one economic agent gives rise to external costs which are borne by other economic agents. Pollution is an example of a negative externality leading to market failure.

Unless the externality is internalized, market outcome will be at intersection of Demand and Private marginal cost (PMC), but when the externality cost is included, PMC increases by amount of the externality cost, therefore Social marginal cost (SMC) lies to the left of PMC. Efficient outcome is at intersection of Demand and SMC curves, which leads to higher price and lower output.

In following graph, market outcome is at point A where D & PMC intersect with price P0 and output Q0. In presence of externality being recognized, socially efficient outcome is at point B where D & SMC intersect with higher price P1 and lower output Q1.

Rahul Sunny answered 2 years ago

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