Market failure

Definition

Market failure occurs when the allocation of goods and services by a free market is not efficient, leading to a net loss of economic welfare. This can arise due to various reasons such as externalities, public goods, and information asymmetries. When market failures happen, the outcome is that resources are not used in the best way possible, often resulting in negative social consequences that require intervention.

5 Must Know Facts For Your Next Test

1. Market failure can occur in various forms, including monopolies, where a single seller dominates the market and can manipulate prices.
2. In cases of externalities, like pollution, the costs imposed on society are not reflected in the price of goods, leading to overproduction and environmental harm.
3. Public goods, such as national defense and public parks, are often underprovided in a free market because individuals may free-ride on the contributions of others.
4. Information asymmetry can lead to adverse selection in markets like insurance, where sellers know more about the product than buyers, resulting in poor choices and inefficiencies.
5. Governments often intervene to correct market failures through regulations, subsidies, or the provision of public goods to enhance overall economic efficiency.

Review Questions

• What are the main causes of market failure and how do they impact economic efficiency?
  • The main causes of market failure include externalities, public goods, and information asymmetries. Externalities occur when the costs or benefits of a transaction affect third parties who aren't involved in the decision. Public goods are underprovided in a free market due to their non-excludable nature. Information asymmetries lead to imbalances in knowledge between buyers and sellers, which can result in poor decision-making. Together, these factors disrupt economic efficiency by preventing optimal resource allocation.
• Discuss how government intervention can help correct market failures and provide examples.
  • Government intervention can help correct market failures by implementing policies that address externalities, provide public goods, and enhance information transparency. For instance, governments may impose taxes on polluting industries to internalize the social costs associated with negative externalities. They might also fund public services like education or infrastructure that are underprovided in a free market. Additionally, regulations requiring companies to disclose important information can help reduce information asymmetry and promote better decision-making among consumers.
• Evaluate the effectiveness of various strategies that governments use to address market failures and their potential drawbacks.
  • Governments employ several strategies to address market failures, such as taxes on negative externalities, subsidies for positive externalities, regulation of monopolies, and the provision of public goods. While these interventions can lead to more efficient outcomes and enhance social welfare, they also have potential drawbacks. For example, taxes might lead to reduced production or economic activity if set too high. Subsidies could distort market signals and result in dependency on government support. Regulations may create compliance burdens for businesses and stifle innovation. Therefore, while government actions can mitigate market failures, they must be carefully designed to avoid unintended consequences.

Related terms

externalities: Costs or benefits incurred by a third party who did not choose to incur those costs or benefits, often leading to market failure when they are not reflected in market prices.

public goods: Goods that are non-excludable and non-rivalrous, meaning that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others, often leading to underproduction in a free market.

information asymmetry: A situation where one party in a transaction has more or better information than the other, which can lead to suboptimal outcomes and market failure.