Market Failure (3.3)

Market Failure

Occurs when the price mechanism in the free market leads to an inefficient or inequitable allocation of resources.

Complete Market Failure/ Missing Market

Occurs when a market does not exist. It might be unprofitable for a firm to supply this service/good. E.g. National Defence.

Partial Failure

When the market produces a price or quantity supplied that is unsatisfactory. If left to market forces, people would be excluded from availing of goods/services as it would be too expensive. E.g. Healthcare.

Asymmetric Information

This market failure occurs when one party(buyer/seller) to an economic transaction has more information than the other party leading to possible exploitation.

Adverse Selection

When sellers/buyers have information that the other does not about product quality.

Moral Hazard

Refers to the lack of incentive an individual or firm May have to safeguard against a risk if they are protected against the consequences of the risk incurred. It involves hidden actions, when one party takes action the other won’t observe but which will affect both of them.

Externality

An externality is a cost or benefit incurred or received by a 3rd party who did not engage in the activity (production or consumption)

Third party

Those not directly involved in the decision making.

Private costs

Costs incurred by a consumer/firm that consumes/produces a good or service.

Private benefit

Benefits that accrue to the consumer/firm that consume/produces a good or service.

External Costs

Costs incurred and paid for by a third party not involved in action.

External benefits

Benefits received by a third party not involved in the action.

Social Costs

The total costs of a particular action (private + external costs)

Social Benefits

The total benefits of a particular action (private + external benefits)

When are externalities positive?

When social benefits > private benefits

When are externalities negative

When social costs > private costs

Negative production externalities

Occurs when third parties are harmed by the production of a good or service. E.g. environment pollution.

Positive production externalities.

Benefits to third parties that are created by producers of a goods or services. E.g. new medicines.

Negative consumption externalities

Created by consumers due to their use of products that can harm third parties who are not involved in the consumption. These goods are often known as demerit goods.

Demerit Goods

Goods whose positive effect are often overestimated by consumers and they have negative effects which consumers possibly underestimate or are unaware off.

Positive Consumption externalities

Spill over effects of consumption of a good or service on others. E.g. third level education.

How can monopoly power be a market failure?

Market failure arises because consumers have fewer products to choose from and monopolists will not always respond to consumers needs.

What market failure issues arise from Monopoly power

1. Allocative Inefficiency: In a monopoly, the single seller sets higher prices, leading to allocative inefficiency where resources aren’t used to maximise consumer satisfaction. This results in consumers paying more and consuming less, causing a deadweight loss to society.

2. Productive Inefficiency: Monopolies lack competitive pressure to minimise costs and innovate, leading to higher production costs and less efficient use of resources.

3. Reduced Consumer Surplus: Consumer surplus is reduced in a monopoly as the monopolist captures more profit, leaving consumers with less benefit from their purchases. Higher prices decrease overall consumer satisfaction and surplus.

4. Barriers to Entry: Monopolies establish barriers to entry, preventing other firms from entering the market and maintaining their dominant position. This restriction reduces competition, innovation and consumer choice, leading to a stagnant market.

How can market failures be overcome?

• Government Provision: If a market does not exist, the government could provide it through taxpayers money. E.g. defence.

• Government Legislation: Producers may be required by law to include all essential information on product labels.

• Taxation and Subsidies: taxes on negative externalities make the consumer/producer pay the full social cost.

• Deregulation: The removal of government control allows for free and competitive marketplaces and companies would become more innovative in their production methods.

Pigouvian tax

A tax on any Market activity that generates negative externalities.

Excise duty

indirect taxes applied to the sale and/or use of goods deemed harmful such as alcohol or tobacco.