Types of Market Failure to Know for Principles of Economics

Market failures happen when the economy doesn't allocate resources efficiently. This can occur due to externalities, public goods, imperfect competition, and more. Understanding these failures helps us see why government intervention is sometimes necessary to improve overall welfare.

1. Externalities

   • Externalities occur when a third party is affected by the economic activities of others, either positively (positive externalities) or negatively (negative externalities).
   • They lead to market failure because the costs or benefits are not reflected in market prices, resulting in overproduction or underproduction of goods.
   • Common examples include pollution (negative externality) and education (positive externality).

2. Public goods

   • Public goods are non-excludable and non-rivalrous, meaning that one person's consumption does not reduce availability for others, and people cannot be easily excluded from using them.
   • Examples include national defense, public parks, and street lighting.
   • The free-rider problem arises, where individuals benefit without contributing to the cost, leading to under-provision of these goods.

3. Imperfect competition

   • Imperfect competition occurs when individual firms have some control over the price of their products, unlike in perfect competition where firms are price takers.
   • Types include monopolies (single seller), oligopolies (few sellers), and monopolistic competition (many sellers with differentiated products).
   • This can lead to higher prices, reduced output, and less innovation compared to competitive markets.

4. Information asymmetry

   • Information asymmetry exists when one party in a transaction has more or better information than the other, leading to an imbalance in decision-making.
   • This can result in adverse selection (e.g., in insurance markets) and moral hazard (e.g., in financial markets).
   • It undermines market efficiency and can lead to market failure as consumers may make uninformed choices.

5. Incomplete markets

   • Incomplete markets occur when not all goods and services are provided in the market, often due to high costs or risks associated with certain products.
   • This can lead to essential goods being unavailable, such as insurance for high-risk individuals or funding for certain public projects.
   • The absence of these markets can hinder economic growth and welfare.

6. Merit and demerit goods

   • Merit goods are those that are deemed beneficial for individuals and society, often under-consumed if left to the market (e.g., education, healthcare).
   • Demerit goods are considered harmful and over-consumed (e.g., tobacco, alcohol).
   • Government intervention is often necessary to promote merit goods and discourage demerit goods to correct market failures.

7. Inequality and income distribution

   • Inequality refers to the uneven distribution of income and wealth within a society, which can lead to social and economic issues.
   • High levels of inequality can result in reduced economic mobility and access to opportunities for lower-income individuals.
   • Addressing inequality often requires government policies such as progressive taxation and social welfare programs.

8. Moral hazard

   • Moral hazard occurs when one party takes risks because they do not bear the full consequences of their actions, often due to insurance or guarantees.
   • This can lead to reckless behavior, particularly in financial markets, where institutions may engage in risky practices knowing they will be bailed out.
   • It highlights the importance of aligning incentives and ensuring accountability to prevent market failures.