SimpleStudy® 1.3 Market Failure Q@ simptestuay 1.3 Market Failure 1.3.1 Types of Market Failure Understanding of Market Failure Market failure occurs when the allocation of goods and services by a free market is not efficient. The main causes include externalities, under-provision of public goods, and information gaps. Types of Market Failure: + Externalities: These occur when the actions of individuals or firms have effects on third parties that are not reflected in the price mechanism. Externalities can be negative (costs imposed) or positive (benefits conferred). + Under-provision of Public Goods: Public goods are characterized by non-rivalry and non- excludability, making them difficult for markets to provide efficiently. Examples include national defense, lighthouses, and clean air. + Information Gaps: These arise when there is asymmetric information between buyers anc sellers, leading to an inefficient outcome in the market. 1.3.2 Externalities Understanding Externalities + Private Costs/Benefits: Costs or benefits that fall directly on an economic agent (individu: or firm) making a decision. + External Costs/Benefits: Costs or benefits that affect third parties who are not directly involved in the economic transaction. * Social Costs/Benefits: The sum of private and external costs/benefits. Diagram Illustrations + External Costs of Production: Represented using marginal analysis to show the difference between market equilibrium and social optimum positions. + Welfare Loss/Area: The area that represents the cost to society of negative externalities not being reflected in market prices. + External Benefits of Consumption: Similar marginal analysis can demonstrate welfare gains when positive externalities are consumed above the market equilibrium level. Impact of Externalities The presence of externalities can lead to a misallocation of resources because not all costs and benefits are considered by the price mechanism. Government interventions, such as taxes and subsidies, can be used to try to correct these market failures.1.3.3 Public Goods Characteristics of Public Goods Public goods, such as street lighting and national defense, are non-excludable (you cannot prevent people from using them) and non-rival in consumption (one person's use does not reduce availability to others). Free-rider Problem This occurs when individuals can enjoy a good without paying for it, knowing that others will Pay. This can lead to under-provision of the good by the private sector since there is no incentive to pay for something that one can use for free. 1.3.4 Information Gaps Asymmetric Information Occurs when one party in a transaction has more or better information compared to the other. This can lead to an adverse selection where poor-quality goods are more likely to be sold, or moral hazard where one party takes risks because they won't bear the full consequences. Misallocation of Resources Imperfect market information can lead to consumers making uninformed decisions, resultin in goods and services not being distributed according to the preferences and needs of the society. Examples include: + Adentist recommending unnecessary work, * Misrepresentations by a used car salesman, * Misleading claims about a financial product, * Insufficient disclosure of health risks by tobacco companies. The government may intervene by providing information to consumers, regulating industries or even providing goods and services directly to correct for information gaps.