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Market Failure: Externalities
Introducing Market Failure
Economics Textbooks Boundless Economics Market Failure: Externalities Introducing Market Failure
Economics Textbooks Boundless Economics Market Failure: Externalities
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Economics
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Causes of Market Failure

Market failure occurs due to inefficiency in the allocation of goods and services.

Learning Objective

  • Explain some common causes of market failure


Key Points

    • A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under produced.
    • Due to the structure of markets, it may be impossible for them to be perfect.
    • Reasons for market failure include: positive and negative externalities, environmental concerns, lack of public goods, underprovision of merit goods, overprovision of demerit goods, and abuse of monopoly power.

Terms

  • free rider

    One who obtains benefit from a public good without paying for it directly.

  • public good

    A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.

  • monopoly

    A market where one company is the sole supplier.


Full Text

Market failure occurs due to inefficiency in the allocation of goods and services. A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under produced.

In order to fully understand market failure, it is important to recognize the reasons why a market can fail. Due to the structure of markets, it is impossible for them to be perfect. As a result, most markets are not successful and require forms of intervention.

Reasons for market failure include:

  • Positive and negative externalities: an externality is an effect on a third party that is caused by the consumption or production of a good or service . A positive externality is a positive spillover that results from the consumption or production of a good or service. For example, although public education may only directly affect students and schools, an educated population may provide positive effects on society as a whole. A negative externality is a negative spillover effect on third parties. For example, secondhand smoke may negatively impact the health of people, even if they do not directly engage in smoking.
  • Environmental concerns: effects on the environment as important considerations as well as sustainable development.
  • Lack of public goods: public goods are goods where the total cost of production does not increase with the number of consumers. As an example of a public good, a lighthouse has a fixed cost of production that is the same, whether one ship or one hundred ships use its light. Public goods can be underproduced; there is little incentive, from a private standpoint, to provide a lighthouse because one can wait for someone else to provide it, and then use its light without incurring a cost. This problem - someone benefiting from resources or goods and services without paying for the cost of the benefit - is known as the free rider problem.
  • Underproduction of merit goods: a merit good is a private good that society believes is under consumed, often with positive externalities. For example, education, healthcare, and sports centers are considered merit goods.
  • Overprovision of demerit goods: a demerit good is a private good that society believes is over consumed, often with negative externalities. For example, cigarettes, alcohol, and prostitution are considered demerit goods.
  • Abuse of monopoly power: imperfect markets restrict output in an attempt to maximize profit.

When a market fails, the government usually intervenes depending on the reason for the failure.

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