Market failure

Definition

Market failure occurs when the allocation of goods and services by a free market is not efficient, leading to a net social welfare loss. This often happens due to various reasons such as externalities, public goods, or monopolies that prevent the market from reaching an optimal equilibrium where supply equals demand.

5 Must Know Facts For Your Next Test

1. Market failure can occur due to positive or negative externalities, where the social cost or benefit diverges from the private cost or benefit.
2. Public goods are a significant source of market failure because they are often underprovided in a free market, as private firms cannot capture enough profit from them.
3. Monopolies lead to market failure by restricting output and raising prices above the competitive level, resulting in decreased consumer surplus.
4. Asymmetric information, where one party has more or better information than the other, can also result in market failures such as adverse selection and moral hazard.
5. Governments often intervene in cases of market failure through regulations, taxes, subsidies, or public provision of goods and services to improve overall welfare.

Review Questions

• How do positive and negative externalities contribute to market failure?
  • Positive externalities occur when a product or service benefits third parties without being compensated, leading to underproduction of those goods. On the other hand, negative externalities impose costs on third parties that aren't reflected in the market price, resulting in overproduction. Both situations prevent the market from achieving an efficient allocation of resources, which is essential for maximizing social welfare.
• What role do public goods play in instances of market failure and how can government intervention address this issue?
  • Public goods are typically underprovided in free markets due to their non-excludable and non-rivalrous nature. Since private firms can't profitably produce these goods, they often rely on government intervention for provision. The government can fund public goods through taxation or direct provision to ensure adequate supply and improve overall societal welfare.
• Evaluate the implications of asymmetric information on market efficiency and how it can lead to market failures.
  • Asymmetric information can severely distort market efficiency by causing adverse selection and moral hazard. In cases like insurance markets, sellers may have more information about risks than buyers, leading to high-risk individuals being more likely to purchase insurance while low-risk individuals opt out. This imbalance skews risk calculations and can cause insurance markets to collapse. Overall, asymmetric information creates inefficiencies that result in market failure by preventing optimal resource allocation.

Related terms

Externalities:

Costs or benefits incurred by a third party who did not choose to incur those costs or benefits, often leading to market failure.

Public Goods: Goods that are non-excludable and non-rivalrous, meaning individuals cannot be effectively excluded from use, and one person's use does not reduce availability for others.

Monopoly:

A market structure characterized by a single seller dominating the market, which can lead to inefficiencies and reduced social welfare.