Question

Using an appropriate diagram to explain how an externality might cause a market failure. How can the market failure be addressed?

Answer 1

Externality leads to market failure because a product price equilibrium does not match the the true costs and benefits of that product. Equilibrium shows the balance between buyers' benefits and producers' costs which results in the optimal level of production. However when there are significant externalities, the equilibrium level is flawed creating incentives that drive individual to make decisions which makes them worse off which is known as a market failure.

The market failure can be addressed by assigning property rights. The property rights are either should be given to the person who is creating the externality ot the person who is consuming the externality so as to achieve the socially optimal output