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

• A. A consumer purchasing a product at its equilibrium price.
• B. A competitive market where prices adjust to equate supply and demand.
• C. A government setting a price ceiling below the equilibrium price.
• D. A factory pollutes a river, imposing costs on nearby residents that are not reflected in the price of its products.

Answer: (D)

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 the role of externalities in market failure: When external costs or benefits are not reflected in market prices, the market outcome is inefficient because the social cost or benefit differs from the private cost or benefit.
4. Analyze the options given: Purchasing at equilibrium price and competitive markets adjusting prices are examples of efficient market outcomes, not failures. Government price ceilings are interventions but not necessarily related to externalities.
5. Focus on the example of a factory polluting a river: This is a classic negative externality where the factory's production imposes costs on residents that are not included in the product's price, leading to overproduction and market failure.