Market Failure

Definition

Market failure occurs when the allocation of goods and services by a free market is not efficient, leading to a loss of economic welfare. This can happen due to various reasons such as externalities, public goods, information asymmetry, and market power. Understanding market failure helps explain why certain goods and services may be under or overproduced and highlights the need for government intervention to correct these inefficiencies.

5 Must Know Facts For Your Next Test

1. Market failure often leads to inefficient resource allocation, which means that some resources are wasted while others are overutilized.
2. Externalities are a common cause of market failure; for example, pollution from a factory affects nearby residents who are not part of the transaction.
3. Public goods like national defense are prone to market failure because they are not provided by the market since individuals cannot be excluded from using them.
4. Asymmetric information can lead to adverse selection and moral hazard, where buyers or sellers take advantage of their information advantages, causing further market inefficiencies.
5. Government intervention, such as regulations, taxes, or subsidies, is often necessary to correct market failures and promote a more efficient allocation of resources.

Review Questions

• What are the main causes of market failure, and how do they disrupt efficient resource allocation?
  • The main causes of market failure include externalities, public goods, asymmetric information, and market power. Externalities can lead to costs or benefits that are not reflected in market prices, causing overproduction or underproduction. Public goods often suffer from free-rider problems, where individuals benefit without paying for the good, leading to under-provision. Asymmetric information creates imbalances in transactions that can result in adverse selection and moral hazard. Together, these factors disrupt efficient resource allocation by preventing markets from responding effectively to supply and demand.
• Evaluate the role of government intervention in addressing market failures. What are some potential benefits and drawbacks?
  • Government intervention plays a critical role in correcting market failures by implementing policies such as taxes, subsidies, and regulations. The benefits include improved resource allocation, reduced negative externalities (like pollution), and provision of public goods that might otherwise be neglected by the market. However, drawbacks include potential government inefficiency and misallocation of resources due to lack of competition or bureaucracy. Additionally, interventions may lead to unintended consequences that could worsen existing problems if not designed carefully.
• Analyze the impact of asymmetric information on market outcomes and how it relates to both adverse selection and moral hazard in terms of market failure.
  • Asymmetric information significantly affects market outcomes by creating conditions where one party has more knowledge than another, leading to adverse selection and moral hazard. In adverse selection, buyers may be unable to accurately assess the quality of a product or service before purchase, resulting in high-quality goods being driven out of the market. In moral hazard, one party may take risks because they do not bear the full consequences of their actions. Both situations exemplify market failure by causing misallocation of resources and preventing optimal transactions from occurring.

Related terms

Externality: A side effect or consequence of an economic activity that affects third parties who did not choose to be involved in that activity, which can be either positive or negative.

Public Goods: Goods that are non-excludable and non-rivalrous in consumption, meaning they are available for everyone to use without reducing their availability to others.

Asymmetric Information: A situation where one party in a transaction has more or better information than the other, leading to an imbalance in the transaction and potentially resulting in market failure.