1.3.1 Types of market failure

Question 1

Understanding of market failure

Answer 1

Market failure occurs when the market fails to allocate scarce resources efficiently, causing a loss in social welfare loss

Question 2

Types of market failure:
externalities

Answer 2

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism

For example, ​cars and cigarettes have negative externalities whilst education and healthcare have positive externalities​.

Question 3

Types of market failure:
under provision of public goods

Answer 3

Public goods are non-rivalry and non-excludable, meaning they are under provided by the private sector due to the free-rider problem

One of the best examples of a public good is ​streetlights​.

Question 4

Types of market failure:
information gaps

Answer 4

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.