ECO SAC - 2 MARKET FAILURE

1. Market Failure & Its Causes

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)


2. Public Goods (Underallocation)

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.

Government Intervention

  • Direct provision: The government funds and produces public goods (e.g., national defense).

  • Subsidies: Financial support to firms producing public goods, ensuring their availability.


3. Externalities

Definition: When a transaction affects third parties not directly involved in production/consumption.

A. Positive Externalities (Underallocation)

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)


B. Negative Externalities (Overallocation)

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)


4. Asymmetric Information (Overallocation)

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)

Moral Hazard

  • Occurs when individuals take higher risks because they don’t bear full consequences.

  • Example: Car insurance → drivers less cautious → higher accident rates.


5. Common Access Goods (Overuse & Intertemporal Inefficiency)

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)


6. Government Failure (Unintended Consequences)

Occurs when government intervention worsens efficiency instead of fixing market failure.

Case Studies:

  1. The Cobra Effect: British bounty on cobras led to cobra breeding → problem worsened.

  2. Cane Toads in Australia: Introduced to control pests → spread uncontrollably.

  3. The Great Sparrow Campaign: Killing sparrows led to locust plagues.

  4. 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.


7. Government Price Intervention

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).