Market failure

Definition

Market failure occurs when the allocation of goods and services by a free market is not efficient, often leading to a net loss of economic value. This can happen due to various reasons, such as externalities, public goods, market power, and information asymmetries, which disrupt the ideal conditions of competitive markets.

5 Must Know Facts For Your Next Test

1. Market failure often results in inefficient resource allocation, which can lead to overproduction or underproduction of goods and services.
2. Natural monopolies are a form of market failure where a single firm can supply the entire market at a lower cost than multiple firms, necessitating regulation to ensure fair pricing and access.
3. In perfect competition, market failure is less likely to occur; however, it can still happen due to externalities or when firms have market power.
4. Social welfare functions are used to evaluate market failures by assessing how income redistribution can address inequalities and improve overall welfare.
5. The free-rider problem arises in the context of public goods, where individuals benefit from resources without contributing to their cost, leading to under-provision of these goods.

Review Questions

• How do externalities contribute to market failure, and what are some potential solutions to address these externalities?
  • Externalities contribute to market failure by causing costs or benefits that affect third parties who are not involved in the economic transaction. For instance, pollution from a factory imposes costs on nearby residents. Solutions include government intervention through taxes on negative externalities or subsidies for positive externalities, which can help internalize these costs and lead to a more efficient allocation of resources.
• Discuss the relationship between public goods and market failure, particularly in terms of the free-rider problem.
  • Public goods are inherently linked to market failure because they are non-excludable and non-rivalrous. This means that once provided, individuals cannot be excluded from using them, leading to the free-rider problem where individuals benefit without contributing. This creates under-provision of public goods since private markets lack the incentive to produce them at optimal levels, necessitating government intervention for their provision.
• Evaluate the implications of asymmetric information on market efficiency and discuss possible regulatory responses.
  • Asymmetric information can severely hinder market efficiency by creating situations where one party has more knowledge than the other, such as in the case of used car sales (the lemons problem). This often leads to adverse selection where low-quality goods dominate the market. Regulatory responses may include enforcing disclosure requirements or creating warranties that protect consumers, thus improving market conditions and efficiency.

Related terms

Externality: A side effect or consequence of an industrial or commercial activity that affects other parties without being reflected in the costs of the goods or services involved.

Public goods: Goods that are non-excludable and non-rivalrous, meaning they can be consumed by many individuals simultaneously without depletion of the good.

Asymmetric information: A situation where one party in a transaction has more or better information than the other party, often leading to an imbalance in the transaction.