If a good causes a negative externality, which market structure would likely cause the least amount of deadweight loss from the transaction of that good?
a) perfect competition
b) monopolistic competition
c) oligopoly
d) monopoly
The correct answer and explanation is:
The correct answer is a) perfect competition.
In a market with perfect competition, the allocation of resources tends to be efficient, meaning that the quantity of a good produced is exactly where the marginal social cost (MSC) equals the marginal social benefit (MSB). However, when a negative externality is present, the market produces more of the good than is socially optimal, because the producers do not account for the external costs (such as pollution or health impacts) in their production decisions. Still, in perfect competition, the price reflects the marginal cost of production, and if government intervention (such as a tax or regulation) is introduced to internalize the negative externality, the market can move closer to the socially optimal quantity.
In monopolistic competition, oligopoly, and monopoly, firms have more market power, meaning they can set prices higher than in perfectly competitive markets. This results in a smaller quantity being produced and higher prices. With a negative externality, firms in these structures have less incentive to reduce production to the socially optimal level because they do not face the same competitive pressures as firms in a perfectly competitive market. In these cases, the deadweight loss would be greater since firms can still produce at levels where the marginal cost exceeds the marginal benefit, leading to inefficient outcomes.
In summary, the presence of competition in a perfectly competitive market forces firms to operate at the lowest possible cost, and with proper intervention (like a Pigovian tax), the negative externality can be corrected with minimal deadweight loss. In contrast, monopolistic structures are less responsive to such interventions, causing more inefficiency and deadweight loss.