Chapter 14: Sources of Market Failure Flashcards
Define market failure
Where resources are inefficiently allocated due to imperfections in the workings of the market mechanism.
Market mechanism
When buyers and sellers coordinate and agree on a price for a good or service.
What does market failure lead to?
Over-provision or under provision of goods and services
What are the 5 sources of market failure?
- Externalities
- Underprovision of public goods
- Imperfect information
- Moral Hazard
- Speculation -> Market Bubbles
Explain externalities as a type of market failure.
The external impact (cost/benefit) on a third party not involved in the economic transaction.
- CAN BE + OR -
- TYPES: consumption/production (both can be either positive or negative)
Prices and profits should be accurate signals, allowing markets to allocate resources efficiently. But this can be misleading because they may not reflect true prices/profits to SOCIETY (e.g it may make commercial sense to cutdown rainforests for livestock production [if the meat industry is booming] but this can lead to an economic disaster in the long-term due to global warming. Therefore the market is putting out the wrong signals leading to misallocation.
Explain the under-provision of public goods as a type of market failure.
Public goods are beneficial for society but under-provided in a free market economy, as there is less opportunity (because they are NON-RIVAL and NON-EXCLUDABLE) so it is relatively easy to gain the benefits of the good without paying the price.
There is then a large incentive for individuals to not pay for the good in the hope that someone else will pay
Information gaps
When economic agents lack the information needed to make a rational decision
Explain information gaps as a source of market failure.
Economic agents lack the information needed to make a rational decision.
- They would not make this decision had they sufficient knowledge regarding it.
- An example is asymmetric information, when either the buyer or seller has more information than the other party.
E.G OF ASYMMETRIC INFORMATION:
A dentist recommends more work than necessary and is more interested in gaining a free than in treating the patient properly. The patient lacks information here.
Goods/services with dangerous side effects would also be sold in lower quantities if buyers were aware of these effects. Similarly, goods/services with extra benefits would be sold in higher quantities if buyers were aware of them
Moral hazard definition
When an individual or organization makes a risky adverse decision knowing that another party will bear the consequences of it
Explain moral hazard as a source of market failure.
They know that someone else will deal with any problems that occur and there is no incentive to take the normal precautions and act sensibly, which may result in unnecessary risk-taking and subsequent failure.
E.G: Banks that acted carelessly and built up massive debts were saved from collapse by the government, which intervened, because, if they had not, the whole the economy would have suffered.
Welfare benefits also prevent some people from not actively seeking work or retraining if they lose their jobs.
Define speculation
When an economic agent buys or sells a financial asset with the expectation that there will be a price change in the future which may lead to profit
Market bubble definition
An economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets
Explain market bubbles as a source of market failure.
MARKET BUBBLE: If everyone expects the value of an asset to increase, people continue to purchase expecting the price to continue rising; this creates the upward pressure on prices and traders respond by buying more and the price keeps rising.
EXPLANATION FOR UNDERSTANDING:
If someone finally decides to sell, the price rise stops and may drop. All those who bought can now expect prices to fall and sell while they still can, making things worse and the bubble bursts with prices dropping dramatically and some traders facing huge losses.
Another example includes housing markets. When it is easy to get a mortgage or interest rates are law, many people buy and house prices rise. The second the economy faces problems or interest rates go up, many owners are forced to sell and the bubble bursts.
Partial market failure
When a market for a good exists but there is too much or not sufficient production of the good.
Missing market
A market where the market mechanism fails to supply any of a good.
