1.3 - Market failure

• a) Understanding of market failure

  occurs when the allocation of resources in a free market results in an inefficient or socially undesirable outcome.

  It indicates that the market, left to its own devices, fails to achieve an optimal allocation of goods and services.
• b) Types of market failure

  1. Externalities

  2. under-provision of public goods

  3. information gaps
• a) Distinction between private costs, external costs and social costs

  1. Private Costs = the costs incurred by producers or consumers directly involved in a transaction or economic activity.

  2. External Costs (Negative Externalities) = costs imposed on third parties who are not part of the transaction or activity.

  3. Social Costs = represent the total costs of an economic activity, including both private costs and external costs.

  They reflect the overall impact of an activity on society, accounting for both direct and indirect costs.
• b) Distinction between private benefits, external benefits and social benefits

  1. Private Benefits = refer to the benefits received by producers or consumers directly involved in a transaction or economic activity.

  2. External Benefits (Positive Externalities) = benefits received by third parties who are not part of the transaction or activity.

  3. Social Benefits = represent the total benefits of an economic activity, including both private benefits and external benefits.

  They reflect the overall positive impact of an activity on society, accounting for both direct and indirect benefits.
• e) The impact on economic agents of externalities and government intervention in various markets

  1. Impact of -ve Externalities:

  Producers may not fully account for external costs, leading to overproduction of goods with negative externalities.

  Consumers may not fully consider external costs, leading to over consumption.

  Overall, negative externalities can result in market inefficiencies and reduced social welfare.

  2. Impact of +ve Externalities:

  Producers may not capture all external benefits, leading to underproduction of goods with positive externalities.

  Consumers may not fully appreciate external benefits, leading to under consumption.

  Overall, positive externalities can result in under allocation of resources to beneficial activities.

  3. Government intervention can correct externalities through policies such as taxes and subsidies.

  Taxes on negative externalities (e.g., carbon taxes) internalise external costs, reducing overproduction.

  Subsidies on positive externalities (e.g., education subsidies) encourage greater provision of beneficial goods and services.

  Regulations can also be used to limit external costs (e.g., emissions standards) or promote external benefits (e.g., safety regulations).
• What are the characteristics of public goods?

  non-rivalrous and non-excludable
• a) Distinction between public and private goods using the concepts of non-rivalry and non-excludability


  1. Private Goods = characterised by two key features: rivalry and excludability.

  Rivalry: Consumption by one individual reduces the availability of the good for others.

  Excludability: Producers or sellers can prevent individuals from consuming the good if they do not pay for it.

  2. Public Goods = characterised by two key features: non-rivalry and non-excludability.

  Non-Rivalry: Consumption by one individual does not reduce the availability of the good for others; it is "non-depletable."

  Non-Excludability: It is difficult or costly to prevent individuals from benefiting from the good, regardless of whether they pay for it.
• b) Why public goods may not be provided by the private sector: the free rider problem

  The free rider problem occurs when individuals can benefit from a public good without having to pay for it.

  Since it is difficult to exclude non-payers, individuals may choose not to pay for the good, assuming that others will pay and they can still enjoy the benefits.

  This leads to under funding or underproduction of public goods in the private market.

  Governments often intervene to provide public goods because they are unlikely to be adequately supplied by the private sector.

  Governments can finance public goods through taxation, ensuring that everyone pays their fair share.
• Quasi-Public Goods


  Some goods exhibit characteristics of both public and private goods. These are referred to as quasi-public goods.

  They may have elements of non-rivalry or non-excludability but not to the same extent as pure public goods.

  Example of a Quasi-Public Good: Toll roads are quasi-public goods. While they are excludable (you must pay to use them), they are non-rivalrous because one person's use does not significantly affect another's ability to use the road
• a) The distinction between symmetric and asymmetric information


  - Symmetric information occurs when all parties in a transaction have equal access to information about the product, service, or market.

  In a symmetric information scenario, buyers and sellers possess the same information, leading to transparent and well-informed decision-making

  - Asymmetric information exists when one party in a transaction has more or better information than the other party.

  This information imbalance can create problems, as the party with less information may make decisions based on incomplete or inaccurate data
• b) How imperfect market information may lead to a misallocation of resources

  1) Imperfect market information = leads to market failure, where resources are allocated inefficiently.

  Market failure occurs when buyers and sellers make suboptimal decisions due to information gaps, resulting in misallocation of resources