1.3.1 Market Failure (Micro)

DEFINITION OF MARKET FAILURE

Market failure occurs when the allocation of resources in a free market results in an inefficient or socially undesirable outcome.

RESULT OF MARKET FAILURE

It results in either a complete absence of a product (missing market) or a partial failure where goods are over/under-produced or priced incorrectly

Market failure often leads to underproduction, overproduction, or misallocation of resources.

Types of Market Failure:

• Externalities

• Under-Provision of Public Goods

• Information Gaps

TYPE OF MARKET FAILURE- 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 spill over effect of the production or consumption of a good or service.

They can be positive (benefits) or negative (costs):

Negative externalities: are costs imposed on third parties not involved in an economic transaction, where social costs exceed private costs

Positive externalities: are beneficial spillover effects from the production or consumption of goods that enhance the well-being of third parties not directly involved in the transaction. 

TYPE OF MARKET FAILURE- UNDER PROVISION OF PUBLIC GOODS

• Public goods are non-excludable and non-rivalrous, meaning that no one can be excluded from their benefits, and consumption by one does not reduce availability to others.

• Because individuals can benefit without paying, there is a tendency for these goods to be underprovided by the private market.

TYPE OF MARKET FAILURE- INFORMATION GAPS

• Information gaps arise when one party in a transaction has more or better information than the other party.

• This can lead to adverse selection and moral hazard problems.