Market failure

Definition

Market failure refers to a situation where the allocation of goods and services by a free market is not efficient, leading to a net loss of economic value. This can happen due to various reasons, such as externalities, public goods, information asymmetries, and market power. In addressing market failure, various government interventions, like antitrust laws and regulatory bodies, aim to promote competition and protect consumer interests.

5 Must Know Facts For Your Next Test

1. Market failure can occur when the market cannot provide efficient outcomes for goods and services, often resulting in either overproduction or underproduction.
2. One common example of market failure is pollution, where the negative externalities of production are not reflected in the cost of goods, leading to societal costs.
3. Antitrust laws like the Sherman Antitrust Act were created to combat market failures caused by monopolies and ensure fair competition.
4. The Federal Trade Commission plays a vital role in addressing market failures by regulating unfair business practices and promoting consumer protection.
5. Natural monopolies arise in industries where high fixed costs make it impractical for multiple firms to compete, often necessitating government regulation to prevent market failure.

Review Questions

• How do externalities contribute to market failure and what are some examples?
  • Externalities contribute to market failure by causing costs or benefits that affect third parties not involved in the transaction. For example, pollution from a factory imposes health costs on nearby residents who are not part of the economic exchange. This leads to an inefficient allocation of resources since the true cost of production is not reflected in the market price, resulting in overproduction of harmful goods.
• In what ways does the Sherman Antitrust Act address issues related to market failure?
  • The Sherman Antitrust Act addresses market failures by prohibiting monopolistic behaviors and promoting competition. It seeks to dismantle trusts and prevent business practices that restrain trade. By ensuring that no single entity can dominate the market, the act helps maintain efficient resource allocation and protects consumers from high prices and limited choices, which are common results of market failures.
• Evaluate the effectiveness of the Federal Trade Commission in mitigating market failures within American markets.
  • The Federal Trade Commission (FTC) plays a crucial role in mitigating market failures by enforcing antitrust laws and protecting consumers from unfair business practices. Its effectiveness can be seen in its ability to investigate monopolistic behaviors, regulate advertising practices, and ensure transparency in markets. However, challenges remain, including adapting to new forms of digital markets where traditional measures may not suffice. A thorough evaluation involves examining both successful interventions and instances where the FTC's actions have fallen short in preventing significant market distortions.

Related terms

Externalities: Costs or benefits that affect third parties who did not choose to incur those costs or benefits, often leading to inefficiencies in market outcomes.

Public Goods: Goods that are non-excludable and non-rivalrous, meaning they are available for everyone to use without depleting their availability for others.

Monopoly:

A market structure where a single seller controls the entire supply of a product or service, leading to market power and potential market failure.