1.3.1 Types of market failure

Question 1

Market failure

Answer 1

When the free market mechanism fails to allocate resources efficiently
- The inefficient allocation of resources
- Occurs when the market fails to allocate scarce resources efficiently, causing a loss of social welfare.

Question 2

Types of market failure

Answer 2

There are three main types of market failure:
1) Externalities
2) Under-provision of public goods
3) Information gaps

Question 3

Externalities

Answer 3

The cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, it is the 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.
For example, cars and cigarettes have negative externalities whilst education and healthcare have positive externalities.

Question 4

Under-provision of public goods

Answer 4

Public goods are non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free-rider problem.
The market is unable to ensure enough of these goods are provided. One of the best examples of a public good is streetlights.

Question 5

Information gaps

Answer 5

Homo economicus is assumed to have perfect information, allowing them to make rational decisions. Similarly, firms are assumed to have perfect information on their cost and revenue curves and governments are assumed to know the full cost and benefits of each decision. In reality, this is not the case.
Therefore, economic agents do not always make rational decisions and so resources
are not allocated to maximise welfare. For example, consumers do not know the quality of second hand products, such as cars, and pension schemes are complex so it is difficult to know which one is best.