Market Failure and its Causes Flashcards
Allocative Efficiency
Achieved when society produces a combination of goods and services that maximises its welfare.
Productive Efficiency
Production using the least cost methods, which maximises the output produced from a given amount of scarce resources.
Equity
A normative issue on how resources should be distributed and requires a value judgement to be made.
Market Failure
Occurs when the market fails to achieve efficiency in the allocation of society’s resources and fails to achieve fairness in the distribution of economic welfare.
Public goods
Non-Excludable and Non-Rivalrous in consumption.
It is technically impossible or extremely costly to exclude non-payers from consuming the good once it is provided. Additionally, the consumption of the good by any individual does not reduce the amount of the good available for consumption by other individuals.
Why are Public Goods not produced?
Non-excludability gives rise to the free rider problem, where people receive benefits from the good without having to pay for it. Since people are able to enjoy the good without having to pay for it, no one will be willing to and thus demand is concealed. Firms therefore will not have any incentive to provide the good at all because it is not profitable.
Non-Rivalrous characteristic implies that the cost of provision to an additional user is zero once the public good has been provided. And hence, any non-zero price would be allocatively inefficient, since an additional person’s enjoyment of the good costs society nothing.
How market fails in the provision of public good?
Due to its characteristics, private firms cannot profitably produce a public good. Thus, public goods are not produced by the free market even though the production of these goods will lead to higher societal welfare. Therefore, zero production of the public goods lead to market failure as society welfare is not maximised.
Negative Externalities
Costs to the third parties who are not involved in the production or consumption of the good and these third parties are not compensated for the costs incurred.
Positive Externalities
Benefits to the third parties who are not involved in the production or consumption of the good and these third parties do not pay for the benefits they receive.
Reasons for Information Failure/ Imperfect Information
Lack of understanding of true costs/benefits: True costs may only be realised in the long term, and underestimated in the short term.
Inaccurate information: Persuasive advertising, which distorts the actual costs and benefits of the goods and services. This results in consumption or production levels which is not economically efficient.
Complex information: Complex products may be difficult to understand and thus may result in imperfect information of the product.
How does Imperfect information lead to market failure
Imperfect information will create a divergence between consumers’ perceived MPB/MPC and the actual MPB/MPC, in addition to any externalities involved.
Merit Goods
Goods and Services deemed socially desirable by the government, and which are under-consumed when left to the price mechanism because of consumers’ failure to recognise the full benefits derived from consumption.
Demerit Goods
Goods and Services deemed socially undesirable by the government, and which are over-consumed when left to the price mechanism because of consumers’ failure to recognise the full costs resulting from consumption.
