1.3.1 Types of market failure

When does market failure occur?

Market failure occurs when the market fails to allocate scarce resources efficiently, causing a loss in social welfare loss.

(ms: when the price mechanism fails to allocate resources efficiently, leads to a net welfare loss)

What are the 3 main types of market failure?

3 main types of market failure=

• externalities

• under-provision of public goods

• information gaps

What are externalities?

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, it is the spillover effect of the production or consumption of a good or service. This leads to the over or under-production of goods, meaning resources aren’t allocated efficiently. For example, cars and cigarettes have negative externalities whilst education and healthcare have positive externalities.

What are the under-provision of public goods?

Public goods are non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free-rider problem (ms: once a public good is provided, it is difficult to make ppl pay for the consumption of it, so there is little financial incentive for firms to supply the good). The market is unable to ensure enough of these goods are provided. One of the best examples of a public good is streetlights

What are information gaps?

Homo economicus is assumed to have perfect information, allowing them to make rational decisions. Similarly, firms are assumed to have perfect information on their cost and revenue curves and governments are assumed to know the full cost and benefits of each decision. In reality, this is not the case. Therefore, economic agents do not always make rational decisions and so resources are not allocated to maximise welfare. For example, consumers do not know the quality of second hand products, such as cars, and pension schemes are complex so it is difficult to know which one is best