Market failure occurs when resources are not allocated efficiently, leading to outcomes that do not maximize societal well-being. Causes include:
Public Goods (underallocation)
Externalities (positive – underallocation, negative – overallocation)
Asymmetric Information (overallocation)
Common Access Goods (overuse and intertemporal inefficiency)
Definition: Goods that are non-excludable (cannot prevent consumption) and non-rivalrous (one person’s use doesn’t reduce availability to others).
Example: Street lighting
Issue: Free rider problem – people benefit without paying → firms cannot profit → underallocation of resources.
Direct provision: The government funds and produces public goods (e.g., national defense).
Subsidies: Financial support to firms producing public goods, ensuring their availability.
Definition: When a transaction affects third parties not directly involved in production/consumption.
1. Positive Externality in Production
Occurs when production provides benefits to society beyond the firm’s private gain.
Example: Research & Development (R&D)
Issue: Firms ignore social benefits → underallocate resources.
Government Intervention:
Subsidies (e.g., government grants for R&D)
Direct production (e.g., state-funded research)
2. Positive Externality in Consumption
Occurs when consumption benefits others beyond the consumer.
Example: Education → better workforce, lower crime.
Issue: Market price doesn’t reflect full social benefits → underallocation.
Government Intervention:
Advertising (to raise awareness)
Subsidies (e.g., student loans, free public education)
1. Negative Externality in Production
Occurs when production imposes costs on society.
Example: Coal-fired power plants → pollution → climate change.
Issue: Firms don’t factor in social costs → produce too much → overallocation.
Government Intervention:
Carbon taxes (internalize social costs)
Regulations (pollution limits)
2. Negative Externality in Consumption
Occurs when consumption harms third parties.
Example: Smoking → secondhand smoke health costs.
Issue: Consumers don’t account for social costs → overallocation.
Government Intervention:
Taxes (higher prices discourage consumption)
Advertising (anti-smoking campaigns)
Definition: One party in a transaction has more knowledge than the other.
Example: Vitamin companies exaggerating health benefits.
Issue: Consumers make poor choices → overallocation to inefficient goods.
Government Intervention:
Consumer protection laws (ACCC enforcement)
Mandatory labeling (e.g., nutritional facts, warning labels)
Occurs when individuals take higher risks because they don’t bear full consequences.
Example: Car insurance → drivers less cautious → higher accident rates.
Definition: Non-excludable but rivalrous resources.
Example: Fisheries, clean air.
Issue: Overuse today → depletion → future generations suffer.
Government Intervention:
Quotas (e.g., fishing limits)
Permits (e.g., carbon emission trading)
Occurs when government intervention worsens efficiency instead of fixing market failure.
The Cobra Effect: British bounty on cobras led to cobra breeding → problem worsened.
Cane Toads in Australia: Introduced to control pests → spread uncontrollably.
The Great Sparrow Campaign: Killing sparrows led to locust plagues.
Rat Conspiracy: Bounty on rats led to rat breeding for profit.
Other Forms of Government Failure:
Tariffs & Protectionism: Protects inefficient industries → misallocation of resources.
Minimum Wages: Higher labor costs → job losses → unemployment.
A. Price Floors (Minimum Prices)
Used when price is too low, leading to overconsumption.
Example: Minimum wage.
Issue: Creates surpluses (excess supply of workers → unemployment).
B. Price Ceilings (Maximum Prices)
Used when price is too high, making goods inaccessible.
Example: Rent control.
Issue: Creates shortages (excess demand → black markets).