Intro to Market Failure Flashcards
Key Idea for Market Failure
There are a number of situations in which the market, through the price mechanism, is not able to deliver the socially optimal allocation of resources. There are a range of reasons why markets do not always work efficiently and effectively, so there are many types of market failure. Market failure may be complete or partial.
What is market failure?
Market failures arise when free markets fail to develop, or when they fail to allocate resources efficiently. Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market.
Individual incentives for rational behaviour do not lead to rational outcomes for the group. Put another way, each individual makes the correct decision for him/herself, but not for the group. In traditional microeconomics, this is evidenced by a steady state of disequilibrium where quantity supplied does not equal quantity demanded.
What is a deadweight loss?
A deadweight loss is a cost to society created by market inefficiency, which occurs when supply and demand are out of equilibrium. It can be applied to any deficiency caused by an inefficient allocation of resources. The price of the product becomes not accurately reflected, meaning goods are either overvalued or undervalued.
Asymmetric Information
A situation where one party to an economic transaction has more or better knowledge than the other party; consumers are less informed than suppliers in almost all economic transactions.
Common property goods
Goods or resources for which there are no clearly defined property rights, so no price can be attached to their use (eg. the ocean, atmosphere, wilderness and space).
Demerit Good
A private good with negative externalities.
Externalities
Indirect costs and benefits associated with the production and consumption of certain goods and services that the market fails to take into account; these benefits or costs are imposed on a third party, who normally cannot pay or be compensated for them through the market mechanism.
Factor immobility
Refers to the ability of factors of production to move, usually to an industry or location where they can operate at a higher level of economic efficiency.
Market Failure
The inability of a market to determine the use and allocation of resources in a way society most desires, because certain conditions are lacking (eg. limited market power, externalities and public goods).
Merit Good
A good or service that is not produced in sufficient quantities by markets because individuals do not value them highly enough; a private good with positive externalities.
Public Good
Goods such as national defence, a beach or road that are non-rival (consumption does not reduce quantity) and can be consumed by people that are not paying for the good.
The tragedy of commons
The overuse or destruction of a common property good because it has no price and so markets do not ration its consumption.
Positive and negative externalities
Goods/services which give benefit to a third party eg. less congestion from cycling.
Merit goods
People underestimate the benefit of the good eg. education
Demerit goods
People underestimate the costs of good eg. smoking
Public Goods
Goods which are non-rival and non-excludable - eg. police, national defence.
Factor Immobility
Geographical/occupational immobility
Information failure
Where there is a lack of information to make an informed choice.
Principal-agent problem
A conflict in priorities between the owner of the asset and the person to whom control of the asset has been delegated. The risk that the agent will act in a way that is contrary to the principal’s best interests can be defined as agency costs.
Monopoly Power
When a firm controls the market and can set higher prices.
Key Terms with Social Factors
SOCIAL BENEFIT: the total benefit to society
Private Marginal Benefit (PMB) + External Marginal Benefit (XMB)
SOCIAL COST: the total cost to society
Private Marginal Cost (PMC) + External Marginal Cost (XMC)
SOCIAL EFFICIENCY: when resources are utilised in most efficiency way.
Social Marginal Cost (SMC) = Social Marginal Benefit.
Complete Failure
A complete market failure exists when free markets are unable to allocate scarce resources to the satisfaction of a need or want. This occurs because there are insufficient incentives to encourage profit-seeking firms to enter a market.
This is commonly the case with pure public goods, such as street lighting, for which there is a need, but private individuals would not be prepared to pay. If no-one is prepared to pay, no revenue can be derived, and no profit earned: hence no firm would enter the market.
Partial Failure
A partial failure can occur in four ways:
- When some but not all necessary conditions for market formation exist. Markets will form, but will fail to develop and supply sufficient quantities of a good or service. eg. Merit good markets are inefficient because they under-supply the goods, and fail to meet society’s demand.
- When free markets over-supply a good or service, either because producers fail to take into account the full costs of production, or because consumers fail to take into account the full costs of consumption to themselves, or society.
- When there is a break-down in self-regulation, as in the case of a financial crisis.
- Where a market becomes highly unstable and fails to return quickly to a stable equilibrum, as in the case of some commodity markets.
