Which of the following is an example of a market failure related to externalities?

• A. A consumer purchasing a product at its market price
• B. A perfectly competitive market with no external effects
• C. Factory pollution that imposes health costs on nearby residents
• D. A firm maximizing profit in a monopolistically competitive market

Answer: (C)

Verified step by step guidance

1. Understand the concept of market failure: Market failure occurs when the allocation of goods and services by a free market is not efficient, often leading to a net social welfare loss.
2. Recognize what externalities are: Externalities are costs or benefits that affect third parties who are not directly involved in the economic transaction. They can be negative (e.g., pollution) or positive (e.g., vaccination).
3. Identify which option involves an externality: Among the choices, 'Factory pollution that imposes health costs on nearby residents' is a classic example of a negative externality, where the factory's production imposes costs on others not involved in the transaction.
4. Confirm that the other options do not represent externalities or market failures: A consumer purchasing at market price is a normal market transaction; a perfectly competitive market with no external effects implies no market failure; and a firm maximizing profit in monopolistic competition is a standard market behavior without necessarily causing externalities.
5. Conclude that the example involving factory pollution illustrates a market failure due to negative externalities, as the social cost exceeds the private cost borne by the firm.