1.3 - Types of market failure Flashcards
market failure
Market failure
Occurs when the allocation of resources in a free market results in an inefficient or socially undesirable outcome from a societal viewpoint. (welfare loss)
What does market failure indicate about the free market
It indicates that the market, left to its own devices, fails to achieve an optimal allocation of goods and services (from a societal viewpoint)
What can market failure lead to
underproduction, overproduction, or misallocation of resources.
What are the types of market failure?
- Externalities
- Under-provision of public goods
- Information gaps
Externalities
The impacts ( costs or benefits ) a third party receives from an economic transaction outside of the market mechanism
> Spillover effect of the production or consumption of a good or service.
This leads to
the over or under-production of goods, meaning resources aren’t allocated efficiently.
What would happen if externalities were acknowledged?
- If these externalities were acknowledged, then the socially optimum price and quantity in the market would be different to the free market price and quantity
(The price mechanism in a free market ignores these externalities)
Example of a negative externality
Air pollution from factories imposes health costs on nearby residents, even if they do not use the factory’s products.
Example of a positive externality
Example of Positive Externality: Vaccination not only benefits the vaccinated individual but also reduces the spread of diseases in the community, benefiting others.
Features of Public goods
- non-excludable
- non-rivalrous
> meaning that no one can be excluded from their benefits, and consumption by one does not reduce availability to others.
Why might public goods be under provided by the private sector/free market?
- Free-rider problem.
> The market is unable to
ensure enough of these
goods are provided - There is less opportunity
for sellers to make
economic profits from
providing these
goods/services
Examples of public goods
national defence, parks, libraries, lighthouses, street lamps
> They are therefore provided by the government for the public benefit
Information gaps
- Arise when one party in a transaction has more or better information than the other party
- exist in all free markets and distort market outcomes, resulting in market failure
What is an underlying assumption of the free market?
- That there is perfect information in the market
> The reality is that in many markets, buyers and sellers have different levels of information. This is called asymmetric information and distorts market prices and quantities
Asymmetric information
When consumers and producers have different amounts of information. One group will have the advantage by knowing more.
Example of information gap: adverse selection
In the used car market, sellers may have more information about the car’s condition than buyers. Buyers may be cautious because they fear purchasing a poor quality car
Example of information gap: moral hazard
Insurance markets can suffer from moral hazard. When individuals have insurance coverage, they may take on riskier behaviours because they are protected from the full consequences of their actions.
Why is understanding market failures crucial for economists and policy makers?
Identifying market failures allows for the design of interventions such as taxes, subsidies, regulations, and public provision to correct these failures and improve overall economic welfare.
Symmetric information
When both consumers and producers have perfect information about the good they are exchanging
