Market Failure

• Market Failure

  where price mechanisms cause inefficient allocation of resources resulting in a net welfare loss
• Under-provision of public goods

  Free rider problem

  • no incentive to pay for freely available goods
  • discourages businesses and firms to produce these goods as they will not make a profit
  • public goods must be freely accessible because they are non-excludable
  • therefore, there are no public goods in a free market economy

  inefficient allocation causes a net welfare loss
• externality

  external and internal
• external costs

  negative effects on a third party (outside transaction)

  eg cigarette consumption -> air pollution

  urbanisation -> light pollution

  alcohol -> violence
• private costs


  costs to the producer and consumer (inside transaction)

  • in a free market economy, producers only care about private costs

  cigarettes -> lung disease, addictiveness, specific tax costs

  sugar -> diabetes, obesity
• social costs

  cost to society

  social costs = private costs +external costs
• marginal cost

  cost derived from 1 additional unit
• Difference between Qfm and Qsol shows


  1. an inefficient allocation in resources
• If the government places an ad valorem on a product, the marginal private costs increase so that the price is increased to Psol and the quantity is reduced to Qsol
• 4 types of Market Failure

  • under provision of public goods
  • External Costs
  • External Benefits
  • Asymmetric Information
• positive externalities/ external benefits

  positive effects on a third party

  eg. perfume/mints/ education
• Private benefits

  benefits to a party involved in a transaction

  eg coat, warmth
• social benefit

  private benefit+ external benefits
• Asymmetric information

  1. information gaps
  2. asymmetric information
• Information gap

  where the consumer and producer doesn't know everything about the product they buy/sell

  leads to an inefficient allocation in resources
• Asymmetric information

  where one party in the economic transaction has more knowledge about the product than the other party involved

  lack of perfect information means that consumers / producers may not allocate resources efficiently