1.3 Market Failure

What are the three 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. This leads to the under-consumption of goods, meaning resources aren’t allocated efficiently.

What is the under-provision of public goods?

Public goods are non-rivalry and non-excludable, meaning they are under provided by the private sector due to free-rider problem.

What are information gaps?

Homo economics is assumed to have perfect information, allowing them to make rational decisions however in reality, that is not the case.

What is private costs/benefits?

They are the costs/benefits to the individual participating in the economic activity.

What does the demand curve represent?

The private benefits

What does the supply curve represent?

The private costs

What is social costs/ benefits?

Social costs/benefits are the costs/benefits of the activity to society as a whole.

What is external costs/benefits?

They are the costs/ benefits to a third party not involved in the economic activity. They are the difference between private costs/ benefits and social costs/benefits.