Study Notes
Market failure occurs when markets do not allocate resources efficiently, leading to overproduction or underproduction of goods compared to the socially optimal level.
- Externalities — when a third party is affected by the production or consumption of a good or service. Example: Pollution affecting non-consumers.
- Under-provision of Public Goods — when goods that are non-excludable and non-rivalrous are not provided by the market. Example: Street lighting not provided due to lack of profit incentive.
- Information Gaps — when one party in a transaction has more or better information than the other. Example: A seller knows more about a car's defects than the buyer.
- Moral Hazard — when a party is protected from risk and behaves differently than they would if they were fully exposed to the risk. Example: Insured individuals taking more risks because they do not bear the full consequences.
- Speculation and Market Bubbles — when asset prices are driven by investor behavior rather than intrinsic value, leading to potential market crashes. Example: Housing market bubbles where prices rise rapidly and then crash.
Exam Tips
Key Definitions to Remember
- Externalities
- Under-provision of Public Goods
- Information Gaps
- Moral Hazard
- Speculation and Market Bubbles
Common Confusions
- Confusing externalities with direct costs or benefits
- Misunderstanding the free-rider problem as a lack of interest
Typical Exam Questions
- What is an externality? An externality is a cost or benefit incurred by a third party who did not agree to it.
- How does the free-rider problem lead to market failure? It leads to under-provision of public goods as individuals can benefit without paying.
- What is asymmetric information? It is when one party has more or better information than the other in a transaction.
What Examiners Usually Test
- Understanding of different sources of market failure
- Ability to explain how each source affects resource allocation