MARKET FAILURE

• Market failure


  When the free market fails to allocate resources to the best interests of society, so there is an inefficient allocation of scarce resources. Economic and social welfare is not maximised where there is market failure.
• Types of market failure

  • Externalities
  • Under-provision of public goods
  • Information gaps
• Externality


  The cost or benefit a third party receives from an economic transaction outside of the market mechanism. It is the spill-over effect of the production or consumption of a good or service.
• Positive externality


  External benefit
• Negative externality


  External cost
• Private costs


  Costs to economic agents involved directly in an economic transaction
• Social costs


  Private costs plus external costs. The cost to society as a whole.
• Marginal social costs (MSC) and marginal private costs (MPC)


  Diverge from each other. External costs increase disproportionately with increased output.
• Private benefit


  Consumers are concerned with the private benefit derived from the consumption of a good. The price the consumer is prepared to pay determines this.
• Social benefit


  Private benefits plus external benefits.
• Social optimum position


  Where MSC = MSB and it is the point of maximum welfare. The social costs made from producing the last unit of output is equal to the social benefit derived from consuming the unit of output.
• Negative externalities


  MSC>MPC of supply. At the free market equilibrium, there are an excess of social costs over benefits at the output between Q1 and Qe.
• Deadweight welfare loss


  The area where social costs > private benefits, shown by the triangle in the diagram.
• External benefits of consumption

  MSB>MPB. This leads to market failure.
• Welfare gain

  The excess of social benefits over costs, shown by the triangle in the diagram.
• Government policies for negative externalities

  • Indirect taxes
  • Subsidies
  • Regulation
  • Provide the good directly
  • Provide information
  • Property rights
  • Personal carbon allowances
• Public goods

  Goods that are non-excludable and non-rival, and they are underprovided in a free market because of the free-rider problem.
• Private goods

  Rival and excludable. For example, a chocolate bar can only be consumed by one consumer.
• Quasi (non-pure) public goods

  Have characteristics of both public and private goods. They are partially provided by the free market.
• Symmetric information

  Consumers and producers have perfect market information to make their decision. This leads to an efficient allocation of resources.
• Asymmetric information

  Unequal knowledge between consumers and producers. This leads to a misallocation of resources.
• Imperfect information

  Information is missing, so an informed decision cannot be made.
• Principal-agent problem


  The agent makes decisions for the principal, but the agent is inclined to act in their own interests, rather than those of the principal.
• Moral hazard


  A party with superior knowledge alters their behaviour in such a way which benefits themselves whilst disadvantaging the party with inferior knowledge.