When does a free market fail?
A)When there is an external effect in either production, consumption, or both
B)When there is government intervention
C)When firms that produce goods which create positive externalities go bankrupt
D)When firms that produce goods which create negative externalities earn high profits

Question

Quizplus · Accepted Answer

A free market fails when there is an external effect or externality which affects either production or consumption, or both. Externalities can be both positive and negative, and when they are not accounted for in the market price, it can result in market failure. For example, pollution is a negative externality, and when firms are not held accountable for their pollution, it can lead to market failure. Similarly, positive externalities like education, research, and development can also lead to market failure if they are not incentivized or accounted for. Government intervention can play a role in addressing these externalities, but ultimately, the market mechanism should be designed to account for such externalities to ensure efficient allocation of resources. Choices B, C, and D may be factors that affect the functioning of the free market, but they alone cannot cause or signal market failure.

When Does a Free Market Fail