1.3 - Market Failure Flashcards
Introduction to Markets and Market Failure - Microeconomics
What is market failure?
It occurs when the free market fails to allocate resources efficiently, leading to a loss of economic and social welfare.
What are the main types of market failure?
*Externalities (positive and negative)
*Under-provision of public goods
*Information gaps
External benefit/Positive externality
The benefits to a third party arising from production and consumption of goods and services
Private benefit
The benefit received by the consumer of a good or service
Social benefit
Private benefits + External benefits.
External cost/Negative externality
The costs to a third party arising from production and consumption of goods and services
Private cost
The cost of an activity to an individual economic unit
How does the price mechanism affect market failure?
The price mechanism does not take into account the full private cost of a good/service but not the external cost.
Social cost
Private cost + External cost
Positive externality diagram
*Marginal Private Benefit (MPB) < Marginal Social Benefit (MSB)
*Market equilibrium: where MPB = MPC
*Social optimum: where MSB = MSC
*Welfare gain: area between MSB and MPB for units underconsumed
What is the consequence of ignoring positive externalities?
Underproduction and underconsumption – potential welfare gain missed
Negative externality diagram
- Marginal Private Cost (MPC) < Marginal Social Cost (MSC)
*Market equilibrium: where MPB = MPC
*Social optimum: where MSB = MSC
*Welfare loss: area between MSC and MPC for units overproduced
What is the consequence of ignoring negative externalities?
Overproduction and overconsumption – deadweight welfare loss.
How do externalities affect economic agents?
*Consumers/producers don’t bear full costs or reap full benefits
*Leads to inefficiencies
*Government may intervene via taxes, subsidies, regulation, or provision
How do indirect taxes correct market failure?
Reduce the quantity of demerit goods consumed through raising the price of the good, or the firm internalises the cost.
How do subsidies correct market failure?
Encourage the consumption of merit goods
How does regulation correct market failure?
Bans could be enforced for the harmful good and reduce consumption or completely remove consumption. Bans are only useful when MSC > MPB.
How does providing the good directly correct market failure?
The government providing public goods corrects the under-provision of something in the free market.
How does providing information correct market failure?
Consumers can make informed economic decisions.
How do property rights correct market failure?
This encourages innovation because entrepreneurs can create new ideas which are protected.
How do personal carbon allowances correct market failure?
Firms can pollute up to a certain amount and trade what they do not use.
Public good
A good that is non-rivalrous (one person’s use doesn’t reduce availability) and non-excludable (you can’t prevent someone from using it).
Private good
A good that is both rivalrous and excludable.
Why are public goods underprovided by the free market?
Because of the free rider problem – individuals benefit without paying, so firms lack incentive to produce them.
What are examples of public goods?
*National defence
*Street lighting
*Flood defences
Quasi public goods
Goods that have characteristics of both public and private goods – they are partially non-rivalrous and partially non-excludable.
What is symmetric information?
When buyers and sellers have equal knowledge about a product or service
What is asymmetric information?
When one party has more or better information than the other (e.g., used car sales, insurance).
How does imperfect information cause market failure?
It leads to misallocation of resources – consumers or producers make suboptimal decisions due to lack of accurate knowledge.
Examples of information gaps?
*Smoking (health risks underestimated)
*Education (long-term benefits not understood)
*Second-hand cars (hidden defects)
Principal agent problem
A situation where one party (the principal) hires another (the agent) to act on their behalf, but the agent acts in their own interest due to conflicting objectives and asymmetric information.
How can the principal-agent problem be reduced?
Through incentives (e.g. performance-based pay) and monitoring (e.g. audits, regulations).
