Market Failure

Definition

Market failure refers to a situation where the free market fails to allocate resources efficiently, leading to a suboptimal outcome for society. This can occur due to various reasons, including the presence of externalities, public goods, imperfect information, and market power.

5 Must Know Facts For Your Next Test

1. Market failure can lead to the underproduction or overproduction of certain goods and services, resulting in a loss of social welfare.
2. Governments can intervene to address market failures through policies such as taxes, subsidies, regulations, or the provision of public goods.
3. Externalities, such as pollution or the benefits of education, can cause market failure because the costs or benefits are not fully reflected in the market price.
4. Public goods, like national defense or public parks, are susceptible to market failure because they are non-rivalrous and non-excludable, leading to the free-rider problem.
5. Imperfect information, such as the lack of knowledge about product quality or safety, can lead to market failure and the need for government intervention.

Review Questions

• Explain how the concept of externalities can lead to market failure.
  • Externalities occur when the production or consumption of a good or service imposes costs or benefits on third parties that are not reflected in the market price. For example, the production of pollution by a factory imposes costs on the surrounding community, but these costs are not borne by the factory. This leads to an overproduction of the good, as the market price does not account for the full social cost. Similarly, the benefits of education extend beyond the individual student to society as a whole, but these positive externalities are not captured in the market price, leading to underinvestment in education. In both cases, the market fails to allocate resources efficiently, resulting in a suboptimal outcome for society.
• Describe how the characteristics of public goods can contribute to market failure.
  • Public goods are characterized by non-rivalry, where one person's consumption does not reduce the availability for others, and non-excludability, where it is difficult to prevent people from accessing the good. These features lead to the free-rider problem, where individuals can benefit from the public good without paying for it. As a result, the private market will underprovide public goods, as producers cannot capture the full value of their investment. For example, national defense is a public good that benefits all citizens, but individual citizens have little incentive to pay for it. This leads to a suboptimal provision of the public good, which is a form of market failure that requires government intervention to ensure an efficient allocation of resources.
• Analyze how asymmetric information can result in market failure and the need for government intervention.
  • Asymmetric information occurs when one party in a transaction has more or better information than the other party, leading to an imbalance of power. This can result in market failure in several ways. For instance, in the market for used cars, the seller typically has more information about the car's condition than the buyer, leading to the 'lemons problem' where good-quality cars are driven out of the market. Consumers, unable to distinguish between high-quality and low-quality cars, will only be willing to pay a price that reflects the average quality, causing the market to fail. Similarly, in the healthcare market, patients often lack information about the quality and appropriateness of treatments, leading to the overuse of unnecessary or ineffective procedures. In these cases, government intervention, such as mandatory disclosures, quality standards, or regulations, can help address the information asymmetry and improve market efficiency.

Related terms

Externality:

A cost or benefit that affects a party who did not choose to incur that cost or benefit.

Public Goods:

Goods that are non-rivalrous and non-excludable, meaning that one person's consumption does not reduce the availability for others, and it is difficult to prevent people from accessing them.

Asymmetric Information:

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