Question

a- Free markets might fail to allocate resources efficiently. Discuss, and provide EXAMPLES, why markets might fail to allocate resources efficeintly.

b- Externalities are a major cause of market failure.

Using a supply and demand diagram, with an example, illustrate an analysis of positive externality in consumption and explain how governments could internalise the effects of a positive externality.

Answer 1

a) Markets fail to allocate resource efficiently when there are weak property rights such that consumption / production by one individual reduce consumption / production for others. Weak property right poses negative externality in the market. Additionally, there can be government intervention in market which can reduce the efficient output such as price ceiling result in shortage of goods while price floor results in surplus of goods and rising unemployment, taxes which reduces output from the efficient level by creating deadweight loss.

b) Positive externality raises social value more than private cost which will result in deadweight loss for the society. As private producers does not get all the benefits from production because of positive externality it pose, there feel lack of incentive to raise production which is socially optimum. Government can provide subsidy to producers to raise output level such that it reduce the deadweight loss.