Registered Environmental Manager (REM) Practice Exam

What describes a market failure?

1. A situation where markets efficiently allocate resources

2. When demand exceeds supply for a prolonged time

3. When the market does not achieve optimal social welfare

4. A temporary imbalance in market prices

The correct answer is: When the market does not achieve optimal social welfare

A market failure occurs when the allocation of goods and services by a free market is not efficient, leading to a loss of economic value or social welfare. This definition revolves around the idea that the market fails to provide the right amount of goods or services that society needs or values, causing social welfare to be suboptimal. When analyzing social welfare, it encompasses not just economic efficiency but also considerations like equity and environmental impacts. Factors leading to market failures can include externalities (where the production or consumption of goods affects third parties), public goods (which are non-excludable and non-rivalrous), and information asymmetries (where one party has more or better information than the other). In these scenarios, the market does not generate the optimal level of production or consumption, thereby hindering the social welfare of the society. While the other choices touch upon aspects of market behavior, they do not fully encapsulate the concept of market failure. For instance, the efficient allocation of resources contradicts the very definition of market failure. Demand exceeding supply for a prolonged period refers more to temporary market pressures, and a temporary imbalance in market prices does not necessarily indicate systemic failure in the market's function, as it can be part of normal market fluctuations.