Market Failure Examples

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Why This Matters

Market failure is the conceptual backbone of welfare economics and public policy analysis. When you're working through intermediate microeconomic theory, you're being tested on your ability to identify why markets deviate from Pareto efficiency and how different interventions might restore optimal outcomes. Every market failure traces back to a violation of the perfectly competitive model's assumptions—whether it's the breakdown of complete information, the presence of unpriced spillovers, or the strategic behavior that emerges when property rights are poorly defined.

These concepts connect directly to your ability to analyze deadweight loss, social welfare functions, and mechanism design. Examiners want to see that you can move beyond simply labeling a failure—they want you to identify the specific efficiency condition being violated, propose appropriate policy responses, and evaluate tradeoffs. Don't just memorize definitions; know which assumption breaks down for each type of failure and how the market outcome diverges from the social optimum.

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Externalities and Spillover Effects

When private costs or benefits diverge from social costs or benefits, markets produce quantities that don't maximize total surplus. The key insight is that decision-makers ignore effects on third parties because those effects aren't priced.

Negative Externalities

• Social marginal cost exceeds private marginal cost—the firm or consumer doesn't face the full cost of their actions, leading to overproduction relative to the social optimum
• Pollution is the canonical example, where the equilibrium quantity $Q_m$ exceeds the efficient quantity $Q^*$ by the amount of the uninternalized external cost
• Pigouvian taxes set equal to marginal external damage at $Q^*$ can restore efficiency by shifting the private cost curve up to match social cost

Positive Externalities

• Social marginal benefit exceeds private marginal benefit—the individual capturing the benefit doesn't account for spillovers to others, leading to underproduction
• Education and R&D generate knowledge spillovers that benefit society beyond the individual's private return on investment
• Pigouvian subsidies equal to marginal external benefit can correct the underprovision by shifting the private benefit curve up to match social benefit

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Public Goods and Non-Excludability

Public goods violate two key assumptions of private markets: excludability and rivalry. When you can't exclude non-payers and consumption doesn't deplete the good, markets systematically underprovide.

Public Goods

• Non-excludable and non-rivalrous—once provided, everyone can consume without reducing availability to others, making private provision unprofitable
• The free-rider problem emerges because rational individuals understate their willingness to pay, knowing they'll benefit regardless of contribution
• Efficient provision requires vertical summation of individual demand curves, since all consumers enjoy the good simultaneously: $\sum_i MB_i = MC$

Common-Pool Resources

• Rivalrous but non-excludable—consumption by one user reduces availability for others, yet no one can be prevented from accessing the resource
• The tragedy of the commons occurs because each user equates private marginal benefit to private marginal cost, ignoring the stock externality imposed on others
• Sustainable management requires mechanisms like quotas, property rights, or community governance to internalize the depletion externality

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Information Failures

When one party knows more than another, markets can unravel or produce inefficient outcomes. The breakdown of the complete information assumption generates distinct pathologies depending on the timing of the information asymmetry.

Adverse Selection

• Pre-contractual information asymmetry—the informed party's private information affects the composition of who participates in the market
• Akerlof's lemons model demonstrates how high-quality sellers exit when buyers can't distinguish quality, potentially causing complete market collapse
• Separating equilibria through signaling (warranties, credentials) or screening (deductibles, menus of contracts) can partially restore market function

Moral Hazard

• Post-contractual information asymmetry—after the agreement is made, the informed party can take hidden actions that affect outcomes
• Insurance markets illustrate the problem: coverage reduces the insured's incentive to exercise care, raising expected losses above pre-contract levels
• Incentive compatibility constraints in contract design (deductibles, co-pays, monitoring) aim to align the agent's behavior with efficient risk management

Principal-Agent Problem

• Delegation with divergent interests—the principal cannot perfectly observe the agent's effort or actions, creating scope for shirking
• The participation constraint ensures the agent accepts the contract; the incentive compatibility constraint ensures the agent chooses the desired action
• Optimal contracts balance risk-sharing against incentive provision, often requiring the agent to bear some risk despite being more risk-averse

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Market Power and Strategic Behavior

When firms can influence prices, the price-equals-marginal-cost condition breaks down. Market power creates a wedge between price and marginal cost, transferring surplus from consumers and destroying some surplus entirely.

Monopoly Power

• Price exceeds marginal cost—the monopolist restricts output to $Q_m$ where $MR = MC$, charging $P_m > MC$ and creating deadweight loss
• The Lerner Index $L = \frac{P - MC}{P} = \frac{1}{|\epsilon_d|}$ measures market power as the inverse of demand elasticity
• Barriers to entry (patents, economies of scale, network effects) sustain supernormal profits and prevent competitive erosion of the price-cost margin

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Market Incompleteness

Even without externalities or information problems, markets may fail to exist for certain goods or contingencies. Missing markets prevent gains from trade that would otherwise occur.

Incomplete Markets

• Not all state-contingent claims are tradeable—individuals cannot fully insure against all risks or trade across all future scenarios
• High transaction costs, thin markets, or verification problems can prevent markets from forming even when gains from trade exist
• Welfare losses arise because resources cannot flow to their highest-valued uses; the first welfare theorem fails when markets are incomplete

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Quick Reference Table

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Self-Check Questions

1. Both public goods and common-pool resources are non-excludable. What property distinguishes them, and how does this difference affect the type of market failure that occurs?

2. A used car dealer offers a 30-day warranty on all vehicles. Is this an example of signaling or screening? Which information problem is it designed to address—adverse selection or moral hazard?

3. Compare the deadweight loss from monopoly pricing to the deadweight loss from a negative externality. In each case, is the market quantity too high or too low relative to the social optimum?

4. An employer cannot observe how hard employees work but can observe output (which depends on both effort and luck). Which market failure does this represent, and what contract features might address it?

5. Explain why the Samuelson condition for public goods requires vertical summation of demand curves rather than the horizontal summation used for private goods. What does this imply about how we should determine optimal provision?