Understanding Market Failure

Market failure: when the free market, through the price mechanism, fails to allocate scarce resources efficiently.

This results in a loss of allocative efficiency and a misallocation of resources from society's point of view.

Outcomes can include:

• Over-provision of some goods and services.
• Under-provision of some goods and services.
• Problems such as inequality, pollution, or a lack of essential services.

Types of Market Failure

Externalities

Externalities: spillover effects on third parties not involved in the original transaction. These effects are not reflected in market prices.

Negative externality: a harmful spillover effect.

• Consumption: for example, smoking through passive smoking and public health costs.
• Production: for example, factory pollution causing environmental and health damage.

Positive externality: a beneficial spillover effect.

• Consumption: for example, education creating a more skilled and productive society.
• Production: for example, beekeeping creating pollination benefits for nearby farms.

Without intervention, markets tend to over-provide goods with negative externalities and under-provide goods with positive externalities.

Public Goods

Public goods would be under-provided or not provided at all by the free market because of two key characteristics:

Non-excludability: it is impossible to prevent non-payers from consuming the good.

Non-rivalry: one person's consumption does not reduce the amount available for others.

Examples: national defence, street lighting, and public parks.

Because firms cannot charge users directly, they have little or no profit incentive to supply these goods, so they are commonly provided by the government.

Information Gaps

Markets rely on consumers and producers having good information to make rational choices.

Asymmetric information: when one party in a transaction has more or better information than the other, distorting the market outcome.

• A seller may know that a used car is faulty, creating a "lemons" problem.
• Consumers may not fully understand complex financial products.
• Consumers may not know the long-term health impacts of certain foods.

The result is that poor choices are made, such as over-consumption of harmful goods or under-consumption of beneficial ones, leading to a misallocation of resources.

Exam Preparation