Module 7.1 Market Failure Lecture

Market Failure Overview

• Market failure occurs when supply and demand do not lead to efficient outcomes.

• Common misconceptions about market failure: it's not just about prices not meeting personal expectations.

Reasons for Market Failure

Externalities

• Definition: Choices made by buyers and sellers that do not reflect the full set of costs and benefits.

  • Example: Driving cars provides personal benefits (e.g., convenience), but individuals often overlook associated costs such as pollution and traffic congestion.

  • Result: Overproduction of driving as individuals do not account for the true marginal cost.

Government Failure

• Definition: Government regulations that create market inefficiencies, leading to underproduction or overproduction.

• Consequence: Results in deadweight loss, similar to market failures caused by private entities.

Market Power

• Definition: Situations where a company has control over pricing (e.g., monopolies).

  • Example: A monopoly controlling all supply of a critical medicine can lead to inefficiencies.

• Consequence: Market outcomes deviate from efficient levels due to lack of competition.

Asymmetric Information

• Definition: A situation where one party has more or better information than the other.

  • Example: A seller of a used car knows more about the car’s condition than the buyer.

• Consequence: Prices may not accurately reflect true costs and benefits, leading to inefficiencies.

Irrationality

• Definition: Systematic errors in decision-making that prevent individuals from aligning marginal cost with marginal benefit.

• Importance: Behavioral economics examines these issues and their impact on market efficiency.

Conclusion

• Markets generally excel at efficiency, delivering products to those willing to pay at the lowest possible prices.

• However, markets have predictable breakdowns (market failures) that can necessitate government intervention.

• Government actions can also fail, as they emerge from individuals pursuing their own self-interest, potentially exacerbating existing problems.