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Study Notes

1.3.1 Types of Market Failure (Edexcel)


Last updated 19 Sept 2023

This study note for Edexcel covers Types of Market Failure

A) Understanding of Market Failure

1. Definition of Market Failure

  • Market failure occurs when the allocation of resources in a free market results in an inefficient or socially undesirable outcome.
  • It indicates that the market, left to its own devices, fails to achieve an optimal allocation of goods and services.

2. Key Points

  • Market failure is not a statement about the failure of markets to function but rather a characterization of outcomes that do not align with societal welfare.
  • Market failure often leads to underproduction, overproduction, or misallocation of resources.

B) Types of Market Failure

1. Externalities

  • Externalities are unintended side effects of economic activities that affect third parties who are not part of the transaction.
  • They can be positive (benefits) or negative (costs).

Example of Negative Externality: Air pollution from factories imposes health costs on nearby residents, even if they do not use the factory's products.

Example of Positive Externality: Vaccination not only benefits the vaccinated individual but also reduces the spread of diseases in the community, benefiting others.

2. Under-Provision of Public Goods

  • Public goods are non-excludable and non-rivalrous, meaning that no one can be excluded from their benefits, and consumption by one does not reduce availability to others.
  • Because individuals can benefit without paying, there is a tendency for these goods to be underprovided by the private market.

Example of Public Good: National defense is a classic public good. People within a country benefit from national security regardless of their contributions.

3. Information Gaps (Asymmetric Information)

  • Information gaps arise when one party in a transaction has more or better information than the other party.
  • This can lead to adverse selection and moral hazard problems.

Example of Information Gap - Adverse Selection: In the used car market, sellers may have more information about the car's condition than buyers. Buyers may be cautious because they fear purchasing a lemon.

Example of Information Gap - Moral Hazard: Insurance markets can suffer from moral hazard. When individuals have insurance coverage, they may take on riskier behaviors because they are protected from the full consequences of their actions.

Understanding market failure and its types is crucial for economists and policymakers. Identifying market failures allows for the design of interventions such as taxes, subsidies, regulations, and public provision to correct these failures and improve overall economic welfare.

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