1.3 Market failure

• Market failure occurs when the market fails to allocate scarce resources efficiently, causing a loss in social welfare
• Three main types of market failure:

  • Externalities: cost or benefit a third party receives from an economic transaction outside of the market mechanism
  • Under-provision of public goods: non-rivalry and non-excludable goods underprovided by the private sector due to the free-rider problem
  • Information gaps: imperfect information leading to irrational decisions and misallocation of resources
• Externalities:

  • Asymmetric markets require government intervention to provide information for informed decisions
  • Private, external, and social costs and benefits differ, affecting the allocation of resources
  • Negative production externalities: social costs greater than private costs, leading to overproduction
  • Positive consumption externalities: social benefits greater than social costs, leading to underproduction
• Government intervention to address externalities:

  • Indirect taxes and subsidies
  • Tradable pollution permits
  • Provision of the good
  • Provision of information
  • Regulation
• Public goods:

  • Non-rivalry and non-excludable characteristics
  • Free rider problem: inability to charge for non-excludable goods, leading to government provision and financing through taxation
• Information gaps:

  • Symmetric information: perfect information
  • Asymmetric information: one party has superior knowledge
  • Advertising leads to information gaps
  • Information gaps lead to market failure and misallocation of resources
  • Examples: drugs, pensions, financial services