The Types of Market Failure

This section explains The Types of Market Failure covering, Understanding Market Failure, Types of Market Failure and provides a Summary of Key Types of Market Failure.

Understanding Market Failure

Market failure occurs when the free market fails to allocate resources efficiently or equitably. This leads to outcomes that are suboptimal for society, causing a loss of economic welfare. In a perfectly competitive market, resources are allocated to produce goods and services in the most efficient way possible, leading to the greatest benefit for society. However, in reality, markets often fail to achieve this outcome, and government intervention may be required to correct these failures.

Key Characteristics of Market Failure:

• Inefficiency: The market fails to produce the right amount of goods or services at the right price.
• Inequality: Some individuals or groups may be unfairly disadvantaged due to the market’s outcomes.
• Welfare Loss: Resources are not being used in the best way to improve overall social welfare.

Market failure can arise for a variety of reasons, including externalities, the under-provision of public goods, and information gaps. Let’s explore the main types of market failure in more detail.

Types of Market Failure

Externalities

An externality occurs when the actions of individuals or firms affect third parties who are not directly involved in the economic transaction. Externalities can be positive or negative, depending on whether they benefit or harm third parties.

Negative Externalities: These occur when the costs of a particular activity spill over onto third parties. A common example is pollution. When firms produce goods that emit harmful pollutants, society bears the costs in terms of health issues, environmental damage, and clean-up costs.

Example:

• Pollution from a factory: The factory emits smoke into the atmosphere, harming the health of nearby residents and contributing to global warming.

Government Intervention:

• Taxes can be applied to internalise the external cost and reduce the harmful behaviour (e.g. carbon taxes or cigarette taxes).

Positive Externalities: These occur when the benefits of a particular activity spill over onto third parties. A common example is education. When individuals invest in their education, society benefits from a more skilled workforce, higher productivity, and lower crime rates.

Example:

• Vaccination: When individuals get vaccinated, they protect not only themselves but also others in society by reducing the spread of disease.

Government Intervention:

• Subsidies can be provided to encourage the consumption of goods with positive externalities, such as education, healthcare, or renewable energy.

Under-Provision of Public Goods

Public goods are goods that are non-rivalrous and non-excludable. This means that one person’s consumption of the good does not reduce its availability to others, and people cannot be excluded from using the good. Public goods often suffer from the free-rider problem, where individuals or firms benefit from the good without paying for it, leading to under-provision in a free market.

• Non-rivalrous: One person’s consumption does not reduce the amount available for others.
• Non-excludable: It is difficult or impossible to exclude individuals from benefiting from the good, even if they do not pay for it.

Example:

• National Defence: Once national defence is provided, everyone in the country benefits, regardless of whether they contribute to funding it.
• Street Lighting: Once street lights are installed, all passers-by benefit from the lighting, whether or not they contribute to its cost.

Government Intervention:

• Since public goods are underprovided in a free market, the government steps in to supply them. Public goods are funded through taxation and are provided for free or at a subsidised price.

Information Gaps

Market failure can also occur when there is an information gap or information asymmetry between buyers and sellers. This happens when one party has more or better information than the other, leading to suboptimal decision-making. Information gaps can result in consumers making poor purchasing decisions, or firms engaging in unfair practices.

Asymmetric Information: Occurs when one party in an economic transaction has more information than the other. For example, a seller might know more about the quality of a product than the buyer.

Example:

• Used Car Market: Sellers of used cars often have more information about the condition of the car than buyers, which can lead to adverse selection, where bad cars are more likely to be sold than good ones.

Moral Hazard: Occurs when individuals or firms are insulated from risk and therefore have an incentive to take on more risk than they otherwise would. This often happens when individuals or firms do not bear the full consequences of their actions.

Example:

• Insurance: When people are insured against theft or accidents, they may be less careful about locking their doors or driving safely because they do not bear the full costs of their actions.

Government Intervention:

Governments can improve market efficiency by regulating industries to ensure that consumers have access to accurate and complete information. Examples of this include:

• Food Labelling Laws: Requiring clear labels on food products to inform consumers of nutritional content.
• Financial Regulations: Mandating transparency in financial markets and ensuring that consumers are informed about financial products.

Summary of Key Types of Market Failure

Summary

Market failure is a critical concept in A-Level Economics. Understanding the types of market failure; externalities, the under-provision of public goods, and information gaps, is key to recognising why markets may fail to achieve socially desirable outcomes. Governments often intervene through taxation, subsidies, provision of public goods, and regulation to address these failures and improve social welfare.

Ensure you understand each type of market failure and the associated government responses, as this knowledge forms a core part of your A-Level Economics studies.