Market failure

Definition

Market failure occurs when the allocation of goods and services by a free market is not efficient, leading to a net social welfare loss. This can arise due to various factors like externalities, public goods, market power, and information asymmetries, which distort the decision-making process of consumers and producers.

5 Must Know Facts For Your Next Test

1. Market failure can lead to overproduction or underproduction of goods, which ultimately results in economic inefficiency.
2. Governments often intervene in markets experiencing failure through regulations, taxes, or subsidies to correct inefficiencies and improve social welfare.
3. The presence of public goods can create a free rider problem, where individuals benefit from resources without contributing to their cost, exacerbating market failure.
4. Positive externalities, like education, can lead to underinvestment in certain areas because individuals may not fully capture the benefits they provide to society.
5. In cases of market power, such as monopolies or oligopolies, the market can fail to provide competitive prices and outputs, reducing consumer welfare.

Review Questions

• How do externalities contribute to market failure and what are some government interventions that can address this issue?
  • Externalities contribute to market failure by imposing costs or benefits on third parties that are not reflected in the market price. For instance, pollution from a factory negatively affects nearby residents but is not accounted for in the cost of production. To address this issue, governments can implement taxes on negative externalities (like carbon taxes) to internalize these costs or provide subsidies for positive externalities (like education) to encourage beneficial activities.
• Discuss the impact of public goods on market failure and the implications for government policy.
  • Public goods create market failure because they are non-excludable and non-rivalrous, leading to underprovision in a purely free market. Since individuals cannot be effectively charged for their use, many choose not to pay for them, resulting in insufficient funding for services like national defense or public parks. Government policy often steps in to provide these goods directly through taxation and ensures they are adequately funded and accessible to all citizens.
• Evaluate the role of information asymmetry in market failure and propose potential solutions that could enhance market efficiency.
  • Information asymmetry plays a significant role in market failure by creating imbalances between buyers and sellers, leading to adverse selection or moral hazard. For example, if consumers cannot accurately assess the quality of a used car, they may be reluctant to pay fair prices. Solutions include government regulations that require transparency (like mandatory disclosures), consumer education initiatives that improve understanding of products, or the establishment of third-party verification systems that enhance trust and information availability in transactions.

Related terms

Externalities: Costs or benefits incurred by third parties who are not involved in the transaction, affecting their welfare without compensation.

Public Goods: Goods that are non-excludable and non-rivalrous, meaning individuals cannot be effectively excluded from use, and one person's use does not reduce availability for others.

Information Asymmetry: A situation where one party in a transaction has more or better information than the other, leading to an imbalance that can result in market inefficiencies.