1.3 market failure

What is market failure

It occurs when the market fails to allocate scarce resources efficiently

What are the three main types of market failure

Externalities, under-provision of public goods, and information gaps

What is an externality

A cost or benefit a third party receives from an economic transaction outside the market mechanism

What is a negative externality

A cost to a third party from a transaction

What is a positive externality

A benefit to a third party from a transaction

How do externalities lead to market failure

They cause over- or under-production of goods

What are the two key characteristics of public goods

They are non-rivalry and non-excludable

What does non-rivalry mean

One person's use of the good does not reduce its availability for others

What does non-excludable mean

People cannot be prevented from using the good

What is the free-rider problem

When people benefit from a public good without paying for it

Why does the free-rider problem lead to market failure

The private sector avoids providing public goods

What is an example of a public good

Streetlights

What is perfect information

When all economic agents have full knowledge to make rational decisions

What is an information gap

When economic agents lack sufficient knowledge to make rational decisions

How do information gaps lead to market failure

They cause a misallocation of resources as decisions fail to maximize welfare

What is asymmetric information

When one party has more knowledge than the other

How does asymmetric information cause market failure

It allows one party to exploit the other

What are examples of information gaps

Second-hand cars

What is an externality

A cost or benefit a third party receives from an economic transaction outside the market mechanism

What are the two types of externalities

Positive externalities and negative externalities

What are private costs

The costs to the individual or firm directly involved in an economic activity

What are private benefits

The benefits to the individual or firm directly involved in an economic activity

What are external costs

The costs to a third party not involved in an economic activity

What are external benefits

The benefits to a third party not involved in an economic activity

What are social costs

The total costs to society

What are social benefits

The total benefits to society

What are negative externalities

External costs that occur when social costs exceed private costs

Where does the market produce when there are negative externalities

At the point where marginal private cost (MPC) equals marginal private benefit (MPB)

Where should production occur to achieve the social optimum

Where marginal social cost (MSC) equals marginal social benefit (MSB)

What is the welfare loss in negative externalities

The shaded area between Q1 (market output) and Q2 (social optimum output)

What are examples of negative production externalities

Noise pollution from airplanes and industrial waste

What are positive externalities

External benefits that occur when social benefits exceed private benefits

Where does the market produce when there are positive externalities

At the point where marginal private cost (MPC) equals marginal private benefit (MPB)

What is the welfare loss in positive externalities

The shaded area between Q1 (market output) and Q2 (social optimum output)

What are examples of positive consumption externalities

Healthcare and education

What is a merit good

A good with external benefits where the benefit to society is greater than to the individual

What is a demerit good

A good with external costs where the cost to society is greater than to the individual

How are merit goods treated in the free market

They are underprovided

How are demerit goods treated in the free market

They are overprovided

What is the role of government in addressing externalities

To internalize external costs and benefits to move production closer to the social optimum

How do indirect taxes address negative externalities

By increasing the cost of goods with external costs

How do subsidies address positive externalities

By reducing the cost of goods with external benefits

What are tradable pollution permits

Permits allowing firms to produce a certain amount of pollution

How does government provision help with positive externalities

By directly providing goods with high social benefits

How does provision of information help with externalities

By reducing information gaps and enabling informed decisions about external costs and benefits

How does regulation address externalities

By limiting or banning harmful goods and activities

Why is it difficult to measure externalities

Because their value often depends on subjective judgments and is hard to monetize

How are information gaps related to externalities

People are often unaware of the full implications of their decisions

What is a public good

A good that is non-rivalry and non-excludable

What does non-rivalry mean

One person’s use of the good does not reduce its availability for others

What does non-excludable mean

People cannot be prevented from using the good

What is an example of a public good

Streetlights

Why are there few pure public goods

Because most goods have some level of rivalry or excludability

What is the free-rider problem

When people benefit from a public good without paying for it

Why does the free-rider problem lead to market failure

Because private firms cannot ensure profit

How is the free-rider problem addressed

Governments provide public goods and fund them through taxation

What are the two key characteristics of public goods

Non-rivalry and non-excludability

Why can private goods be excluded from public provision

Because private goods are both rival and excludable

Why doesn’t the private sector provide public goods

They cannot guarantee profit due to the non-excludability of public goods

How do governments typically provide public goods

Through taxation and public funding

What is a commonly cited example of a public good

National defense

How do streetlights exemplify public goods

They are non-rivalry and non-excludable

What is symmetric information

A situation where buyers and sellers have equal access to the same information

What is an information gap

A lack of sufficient information

What is asymmetric information

A situation where one party has more information than the other in a transaction

Who usually has superior knowledge in asymmetric information

Sellers typically have more information than buyers

How do information gaps cause market failure

They lead to a misallocation of resources as consumers and producers make suboptimal decisions

Why can asymmetric information lead to higher prices

Sellers exploit buyers’ lack of knowledge to charge more

What is an example of an information gap in healthcare

Patients may lack the knowledge to evaluate the necessity or effectiveness of medical treatments

How do information gaps affect pension schemes

Young people may not understand the long-term benefits of saving into pension schemes

What is an example of information gaps in financial services

Financial institutions may exploit consumers’ lack of understanding to sell unsuitable products (moral hazard)

How do information gaps relate to drugs

Users may not understand the long-term consequences of drug use

How does advertising contribute to information gaps

It often exaggerates benefits

How has technology impacted information gaps

Technology reduces information gaps by providing easier access to information

What is a key outcome of information gaps in markets

Consumer demand or producer supply may be too high or too low