Answer to Question #56675 in Microeconomics for Thashini

Question

How does negative externalities lead to market failure in sugar market?
Need a diagram to support the answer
10 marks

Answer 1

Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption.
Because when you have a negative externality for example, this means that the social cost is higher than the private cost. The difference between the social cost and private cost is the externality, or the spill over effect to third parties.
What this means is that the product is being over produced because the social costs mean people are less likely to buy or use it.
The product being over produced means that there is allocative inefficiency (if you don't know what this means look it up in your book), because too many scarce resources are being used. This is market failure (the misallocation of resources).