Definitions
- Market Failure: A situation where the market fails to allocate resources efficiently, leading to a loss in social welfare.
- Externalities: Costs or benefits that affect parties who did not choose to incur those costs or benefits.
- Public Goods: Goods that are non-excludable and non-rivalrous, meaning they are available to all and one person’s use doesn’t reduce its availability to others.
- Merit Goods: Goods that are under-consumed if left to market forces. Examples include education and healthcare.
- Demerit Goods: Goods that are over-consumed if left to market forces. Examples include cigarettes and alcohol.
- Information Asymmetry: A situation where one party has more or better information than the other, creating an imbalance of power.
- Monopoly: A market structure where there is only one producer/seller for a product.
- Oligopoly: A market structure in which a few firms dominate the market.
- Price Mechanism: The system where the forces of supply and demand interact to determine the price of goods and services.
- Allocative Efficiency: A state of the economy in which production represents consumer preferences.
- Productive Efficiency: A situation where the economy could not produce any more of one good without sacrificing the production of another good.
- Social Welfare: The overall well-being of the entire society.
- Free Rider Problem: The issue that arises when people can enjoy a good service without paying for it.
- Tragedy of the Commons: A situation where individuals acting in their own self-interest deplete shared resources.
- Government Intervention: Actions taken by a government to correct market failures.
- Pigovian Tax: A tax levied on any market activity that generates negative externalities.
Types of Market Failure
Public Goods
- Definition: Goods that are non-excludable and non-rivalrous, meaning people can’t be prevented from using them, and one person’s use doesn’t reduce its availability for others.
- Real-World Example: National defense is a public good because it protects everyone in a country, regardless of whether they pay taxes.
Externalities
- Definition: Costs or benefits that affect third parties not directly involved in a transaction.
- Positive Externalities: Benefits to third parties.
- Negative Externalities: Costs to third parties.
- Real-World Example:
- Positive: Vaccination provides herd immunity, benefiting even those who aren’t vaccinated.
- Negative: Air pollution from factories affects the health of nearby residents.
Information Asymmetry
- Definition: A situation where one party in a transaction has more or better information than the other.
- Real-World Example: Used car sales, where the seller knows more about the car’s condition than the buyer.
Monopoly Power
- Definition: Occurs when a single firm controls a large portion of the market, leading to higher prices and lower output.
- Real-World Example: De Beers had a monopoly on the diamond market for most of the 20th century, controlling prices and supply.
Solutions to Market Failure
1. Government Regulation
- Description: The government can impose laws and regulations to correct negative externalities.
- Real-World Example: Emission standards for factories to reduce pollution.
2. Taxation and Subsidies
- Description: Taxes can be levied on harmful products, while subsidies can be provided for beneficial ones.
- Real-World Example: Carbon tax on fossil fuels, subsidies for renewable energy.
3. Public Provision
- Description: The government can directly provide public goods.
- Real-World Example: Public funding for national defense or public parks.
4. Creating Property Rights
- Description: Assigning property rights can solve issues like overfishing or deforestation.
- Real-World Example: Fishing quotas to prevent depletion of fish stocks.
5. Information Dissemination
- Description: Spreading information can correct information asymmetry.
- Real-World Example: Mandatory labeling of food products.
6. Breaking Up Monopolies
- Description: Anti-trust laws can be used to break up or regulate monopolies.
- Real-World Example: The breakup of AT&T into smaller companies in the 1980s.
7. Pigovian Taxes
- Description: Taxes that are equal to the external cost or benefit of a good.
- Real-World Example: Tax on cigarettes to account for healthcare costs.
8. Tradable Permits
- Description: Allow companies to buy and sell the right to emit a certain amount of pollution.
- Real-World Example: The European Union Emission Trading System (EU ETS).
Mark is an A-Level Economics tutor who has been teaching for 6 years. He holds a masters degree with distinction from the London School of Economics and an undergraduate degree from the University of Edinburgh.