1.3. Market Failure

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

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


  The cost or benefit a third party receives from an economic transaction outside of the market mechanism
• Goods with externalities


  • Cars and cigarettes have negative externalities
  • Education and healthcare have positive externalities
• Public goods


  Non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free-rider problem
• Public good


  • Streetlights
• Information gaps


  Economic agents do not have perfect information, so they do not always make rational decisions and resources are not allocated to maximise welfare
• Information gaps


  • Consumers do not know the quality of second hand products, such as cars
  • Pension schemes are complex so it is difficult to know which one is best
• When there are asymmetric markets, the government provides information to allow people to make informed decisions
• Private costs/benefits


  The costs/benefits to the individual participating in the economic activity
• Social costs/benefits


  The costs/benefits of the activity to society as a whole
• External costs/benefits


  The costs/benefits to a third party not involved in the economic activity
• Merit good


  A good with external benefits, where the benefit to society is greater than the benefit to the individual
• Demerit good


  A good with external costs, where the cost to society is greater than the cost to the individual
• Marginal private benefit (MPB)


  The extra satisfaction gained by the individual from consuming one more of a good
• Marginal social benefit (MSB)


  The extra gain to society from the consumption of one more good
• Marginal private cost (MPC)


  The extra cost to the individual from producing one more of the good
• Marginal social cost (MSC)


  The extra cost to society from the production of one more good
• Negative production externalities


  Social costs are greater than private costs, so the market will produce more than the socially optimal amount
• Positive consumption externalities


  Social benefits are greater than social costs, so the market will produce less than the socially optimal amount
• It is difficult to work out the size of the externality as it tends to be placed on value judgements, since it is difficult to monetise external costs
• Many externalities are involved with information gaps, as people are unaware of the full implications of their decisions
• Government interventions to address externalities

  • Indirect taxes and subsidies
  • Tradable pollution permits
  • Provision of the good
  • Provision of information
  • Regulation
• Non-rivalry


  One person's use of the good doesn't stop someone else from using it
• Non-excludable


  You cannot stop someone from accessing the good and someone cannot chose not to access the good
• Free rider problem


  You cannot charge an individual a price for the provision of a non-excludable good because someone else will gain the benefit from it without paying anything
• Symmetric information


  Buyers and sellers have potential access to the same information; this is perfect information
• Asymmetric information


  One party has superior knowledge compared to another, usually the seller has more information than the buyer
• Most advertising leads to information gaps as it is designed to change attitudes of the consumers to encourage them to buy the good
• Increases in technology mean information gaps are on the decline as people can get more information
• Information gaps lead to market failure as there is a misallocation of resources because people do not buy things that maximise their welfare
• Information gaps


  • Drugs, where users do not see the long term problems
  • Pensions, where young people do not see the long term benefits of paying into their pension schemes
  • Financial services, where the suppliers have more information than the consumers so abuse their customers for their own benefit (moral hazard)