Types of Market Failure

Introduction to Market Failure

• Market failure occurs when the free market fails to allocate resources efficiently, leading to a misallocation of resources and a reduction in society’s overall well-being or living standards.
• In a perfectly competitive market, resources are allocated to their highest valued uses, maximizing allocative efficiency and technical efficiency.
• Market failures justify government intervention to improve resource allocation and increase social welfare.

KEY TAKEAWAY: Market failure means the free market isn’t delivering the best outcome for society, justifying potential government intervention.

Types of Market Failure

1. Public Goods

• Definition: Public goods are non-excludable and non-rivalrous, meaning that it is impossible to prevent people from consuming the good (non-excludable) and one person’s consumption does not diminish the amount available for others (non-rivalrous).
• Characteristics:
  • Non-excludability: Suppliers cannot prevent non-payers from enjoying the benefits.
  • Non-rivalry: One person’s consumption does not reduce the amount available for others.
• Examples: National defense, street lighting, clean air.
• The Free-Rider Problem: Because individuals can benefit from a public good without paying for it, there is little incentive for private firms to supply it. This leads to under-provision of public goods by the market.
• Market Failure: Public goods are under-supplied by the market because private firms cannot generate a profit. This leads to a misallocation of resources, as the quantity supplied is less than the socially optimal level.

APPLICATION: National defense is a classic public good. If one person is protected, everyone in the country is protected. It’s impossible to exclude anyone, and one person’s protection doesn’t diminish the protection available to others.

2. Externalities

• Definition: An externality occurs when the production or consumption of a good or service imposes a cost (negative externality) or benefit (positive externality) on a third party who is not involved in the transaction.

• Types:

  • Negative Externality: A cost imposed on a third party.
    • Examples: Pollution from factories, noise pollution from airports, smoking.
    • Market Failure: Over-production of the good, as the market only considers the private costs and benefits, not the social costs.
    • Diagram Description: The supply curve represents the private marginal cost (PMC). The social marginal cost (SMC) is higher than the PMC due to the external costs. The market equilibrium occurs where PMC = Demand, resulting in a higher quantity produced than the socially optimal level where SMC = Demand.
  • Positive Externality: A benefit conferred on a third party.
    • Examples: Education, vaccinations, research and development.
    • Market Failure: Under-production of the good, as the market only considers the private benefits and costs, not the social benefits.
    • Diagram Description: The demand curve represents the private marginal benefit (PMB). The social marginal benefit (SMB) is higher than the PMB due to the external benefits. The market equilibrium occurs where PMB = Supply, resulting in a lower quantity produced than the socially optimal level where SMB = Supply.

• Market Failure: Externalities cause a divergence between private and social costs or benefits, leading to an inefficient allocation of resources. Negative externalities result in overproduction, while positive externalities result in underproduction.

EXAM TIP: When discussing externalities, always clearly identify who the third party is and how they are affected.

3. Asymmetric Information

• Definition: Asymmetric information occurs when one party in a transaction has more information than the other party.
• Types:
  • Adverse Selection: Occurs before a transaction. One party uses private knowledge of a situation to their advantage in a transaction.
    • Example: In the used car market, sellers know more about the car’s condition than buyers. This can lead to buyers being unwilling to pay a fair price, resulting in only low-quality cars being offered for sale.
  • Moral Hazard: Occurs after a transaction. One party changes their behavior after a transaction because they are shielded from the full consequences of their actions.
    • Example: After purchasing insurance, individuals may take less care to prevent losses, knowing that the insurance company will cover the costs.
• Market Failure: Asymmetric information can lead to inefficient outcomes, such as reduced market participation, lower quality goods, and increased risk.

COMMON MISTAKE: Confusing adverse selection and moral hazard. Remember, adverse selection happens before the transaction, while moral hazard happens after.

4. Common Access Resources

• Definition: Common access resources are non-excludable but rivalrous, meaning that it is difficult to prevent people from using the resource, but one person’s use reduces the amount available for others.
• Examples: Fisheries, forests, clean air, water.
• The Tragedy of the Commons: Individuals tend to overuse common access resources because they do not bear the full cost of their actions. This leads to depletion or degradation of the resource.
• Market Failure: Common access resources are over-exploited because the market fails to account for the external costs of resource depletion.

VCAA FOCUS: VCAA often asks about policies to address the overuse of common access resources, such as quotas, taxes, and property rights.

Summary Table

STUDY HINT: Create flashcards for each type of market failure, including the definition, characteristics, examples, and resulting market outcome.

Government Intervention

• Governments can intervene in markets to correct market failures and improve resource allocation.
• Common interventions include:
  • Public Goods: Direct provision of the good or service.
  • Negative Externalities: Taxes, regulations, and permits.
  • Positive Externalities: Subsidies, education campaigns.
  • Asymmetric Information: Regulations requiring disclosure of information.
  • Common Access Resources: Quotas, taxes, property rights.

REMEMBER: Government intervention is not always perfect. It can sometimes lead to government failure, where the intervention makes the situation worse.