16.3 Market Failures LO 3, 4, 5
Market failure refers to situations in which the free market does not
achieve allocative efficiency. Four main sources of market failure are
1. market power
2. externalities
3. public goods
4. information asymmetries
Pollution is an example of an externality. A producer who pollutes
the air or water does not pay the social cost of the pollution and is
therefore not motivated to avoid the costs. Private producers will
therefore produce too much pollution relative to what is allocatively
efficient.
National defence is an example of a public good. Markets fail to
produce public goods because the benefits of such goods are available
to people whether they pay for them or not.
Information asymmetries cause market failure when one party to a
transaction is able to use personal expertise to manipulate the
transaction in his or her own favour. Moral hazard and adverse
selection are consequences of information asymmetries.