Analysis of Market Failure

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Market Failure

Market failure occurs when the free market fails to allocated resources in an optimum and efficient manner. There are four main sources of market failure:

1) Externalities

Externalities occur when some of the costs or benefits associated with production or consumption of goods and services spill over onto third parties. When market failure is present, allocative efficiency is achieved when MSB=MSC

|Positive externalities |Negative externalities | |Occur when society benefits from the consumption or production of a |Occur when costs are imposed on society from the consumption or | |commodity or service |production of a commodity or service | |Education, vaccination etc. |Pollution, smoking etc. |

|Merit goods |Demerit goods | |Goods that society values and judges that everyone should have |Goods that society values and judges to be bad for and individual | |whether the individual wants them or not. | | |Underconsumed due to imperfect information – individuals are |Overconsumed due to imperfect information – individuals are unaware | |unaware of long-term benefits and positive externalities |of long-term detriments and negative externalities | |Consumption of merit goods is believed to generate positive |Consumption of demerit goods leads to a fall in social welfare (MPB | |externalities (MSB exceeds MPB) |exceeds MSB) | |Healthcare, education, public libraries |Alcohol, cigarettes, drugs, addiction to gambling |

2) Zero Provision of Public Goods

A public good is a good/service which is
1. Non-rivalrous – its benefits are not depleted by an additional user o MC = 0, for allocative efficiency, P = MC = 0
o Public goods have to be provided at no charge
2. Non-excludable – impossible (or difficult) to exclude people from its benefits o ‘Free rider’ problem arises – no one will pay for what he can get free o Private firms will not provide public goods (unable to charge for consumption) o Public goods, therefore, have to be provided by the government Examples of public goods include streetlamps and public libraries Note: a private good is one that is both rivalrous and excludable – automobiles, clothing, food etc.

3) Imperfect Competition

Prefect competition does not always exist in real markets, and more often than not, free market forces do not lead to optimum efficiency in resource allocation. One example is the monopoly: the monopolist’s output is not allocative efficient as it produces at a point where P > MC, creating a DWL of both consumer and producer surplus.

4) Inequity

The problem of inequity is distinct from that of inequality. Equity refers to a distribution of income that is considered fair – a normative issue. An equitable distribution is thus not the same as an equal distribution. While to some extent, some degree of income inequality is desirable – as incentives to work hard etc., a very unequal distribution of income has negative repercussions especially on the socioeconomic front. The solutions to inequity are briefly discussed under “Dealing with Inequality and Inequity”

Government Intervention

|Problem |Intervention |Evaluation | |Zero provision of public|Direct...
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