Question

Market failure occurs when there is an inefficient allocation of resources in a market. Externalities are a type of market failure. For a market to work as efficiently as possible, two things must happen. First, each participant must be able to evaluate the internal costs of participation. Second, for a market to work efficiently, the external costs of production must be internalized." What is a crucial condition for a market to function efficiently according to the passage?

a) Internal costs need evaluation
b) External costs should be eliminated
c) Participants' understanding of external costs
d) Internalizing external production costs

Answer 1

A crucial condition for a market to function efficiently is the internalization of external production costs. This means that the external costs of production must be included in the decision-making process of firms and considered as part of the overall costs of production.

Step-by-step explanation:

A crucial condition for a market to function efficiently is the internalization of external production costs. This means that the external costs of production must be included in the decision-making process of firms and considered as part of the overall costs of production. When external costs are internalized, the market can properly account for the social costs and benefits, leading to a more efficient allocation of resources.

For example, let's consider the case of pollution as an externality. If firms that generate pollution are not required to bear the costs of environmental damage and healthcare expenses caused by pollution, they will not factor these costs into their production decisions. As a result, the market will produce more pollution than would be socially optimal. However, if the external costs of pollution are internalized, firms will have to consider and account for these costs, leading to a more efficient level of pollution reduction.