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

• A. A competitive market where supply equals demand and there are no external effects.
• B. A consumer choosing between two brands of cereal based on price and taste.
• C. A monopolist setting a higher price due to lack of competition.
• D. A factory pollutes a river, imposing costs on nearby residents not reflected in the price of its products.

Answer: (D)

Verified step by step guidance

1. Step 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. Step 2: Recognize what externalities are. Externalities are costs or benefits that affect third parties who are not involved in the economic transaction. They can be negative (e.g., pollution) or positive (e.g., vaccination).
3. Step 3: Identify that a market failure related to externalities happens when these external costs or benefits are not reflected in the market prices, causing overproduction or underproduction of goods.
4. Step 4: Analyze the options given: a competitive market with no external effects is efficient; consumer choice between brands is a normal market behavior; a monopolist's pricing is a different type of market failure (market power), not externalities.
5. Step 5: Conclude that the example of a factory polluting a river, imposing costs on nearby residents not reflected in the product price, is a classic case of negative externality causing market failure.