1.3.

5 Market failure

Sources of Market Failure - existence of externalities, an under-provision of public goods, and

the existence of information gaps in markets

Externalities (EXTERNAL IMPACTS ON PRODUCTION AND CONSUMPTION)

Externalities occur when there is an external impact (cost or benefit) on a third party not
involved in the economic transaction. They affect production and comsumption

The price mechanism in a free market ignores these externalities

A private cost/benefit for the producer is what they actually pay to produce a good/service

An external cost/benefit (negative/positive externality) is the damage not factored in to the

economic activity (for example, generating air pollution when producing electricity)

Private cost/benefit + external cost/benefit = social costs/benefit

External benefits occur when the social benefits of an economic transaction are greater than the
private benefits

Marginal analysis in economics considers the cost or benefit of the next unit produced or
consumed

The marginal private cost (MPC) is the cost of the next unit produced or consumed

The marginal private benefit (MPB) is the benefit derived from the production or consumption of
the next unit

Public Goods (GOVERMENT SERVICES TO PUBLIC )

Public goods are beneficial to society but would be under-provided by a free market as there is
less opportunity for sellers to make economic profits from providing these goods/services

‘free rider’ problem

This is a situation where customers realise that they can still access the goods, even without
paying for them

Information Gaps (MISINFORMATION)

The distinction between symmetric and asymmetric information

Symmetric information: Both parties in a transaction have equal knowledge.

Asymmetric information: One party has more information than the other, giving them an
advantage.
 Moral hazard-Moral hazard happens when one party takes risks because they know someone
else will bear the consequences. In insurance, it leads to more reckless behavior, increasing
costs for both consumers and insurers. In banking, it can result in riskier investments since
depositors' money is insured, potentially causing financial instability and bailout burdens on
governments

Speculation and market bubbles-

Speculation involves buying or selling assets with the expectation of making a profit based on
anticipated price movements, rather than the intrinsic value of the asset.

Market bubbles occur when speculation drives asset prices significantly above their fundamental
value, often fueled by investor optimism, excessive borrowing, or herd mentality . Bubbles
eventually burst when reality sets in, leading to sharp declines in asset prices and significant
economic repercussions.

Government Intervention in Markets- Prevent overexploitation of resources, earn taxation

revenue, prevent inequality, support firms and key industries, support poorer households, Trade
Pollution Permits , State Provision of Public Goods , Provision of Information

Methods of intervention - indirect taxation, use of subsidies, maximum prices, and minimum
prices

Market Failure due to Goverment Intervention (GOVERNMENT FAILURE) -

CAUSES- Distortion of Price Signals , Unintended Consequences (SELFISH INTENTS) ,

Excessive Administrative, monitering Costs, Misinformation,