1.3.1 Types of Market Failure

What is Market Failure

when the price mechanism leads to an inefficient allocation of resources and a deadweight loss of economic welfare

scarce resources are

the FoP (land, labour, capital, enterprise)

what does the price mechanism do in a free market

determines the most efficient allocation of scarce resources in response to competing wants and needs in the marketplace

what are the things market failure can lead to

• over provision of goods and services/over-allocation of resources

• under provision of goods and services/under-allocation of resources

  essentially a lack of allocative efficiency, or a misallocation of resources

types of market failure

• externalities (positive or negative)

• public goods

• information gaps

what is an externality

the unintended side effects of economic activities that affect third parties who are outside the price mechanism

what is a positive externality of consumption/production

when the impact on a 3rd party is positive

what is a negative externality of consumption/production

when the external impact on a third party is negative

what happens when an externality is acknowledged

the socially optimum price and quantity in the market would be different to the free market price and quantity

does the price mechanism in a free market ignore these externalities

yes

what are public goods

goods that are non-excludable and non rivalrous

what does non-excludable mean

no one can be excluded from the benefits of the public good

what does non-rivalrous means

consumption by one does not reduce availability to other

why are public goods underprovided by a free market

there is less opportunity for sellers to make economic profits from providing these goods/services

what are information gaps

when one party in a transaction has more or better information than the other party

what two problems can information gaps lead to

• adverse selection

• moral hazard problems

what is asymmetric information

when buyers and sellers have different levels of information

adverse selection

sellers have more info about a product than buyers, buyers may then be more cautious

moral hazard

when consumers take on riskier behaviours because they are protected from the full consequences of their actions