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Sources of Market Failure (Public Goods (Non-excludable in consumption (A…
Sources of Market Failure
Public Goods
Non-excludable in consumption
A person cannot be excluded from consumption of a good even if they do not pay for it
Consumers will hide their ability and willingness to pay since they can get the good for free = No effective demand
Since no one is willing and able to pay for the good, there is no effective demand. Without effective demand, producers will not produce the good
Society's welfare is not maximimised as no resources are allocated to producing the good in the free market. Complete market failure due to the absence of the market. Hence, there is market failure which requires government intervention.
Non-rivalrous in consumption
Consumption of good by one more person does not leave less for others
MC of producing next unit of good = 0. For there to be allocative efficiency, producers produce at P=MC, P=0. Since society consumes as MSC=MSB, MSB=0 which reflects price.
Producers being profit-maximising will not produce a good for free
Society's welfare is not maximimised as no resources are allocated to producing the good in the free market. Complete market failure due to the absence of the market. Hence, there is market failure which requires government intervention.
Information Failure
Imperfect Information
Ex. Demerit good are under-consumed due to consumers having imperfect information
There is a deadweight loss to society because of the underconsumption (Between QsQf, MSC>MSB)
Society's welfare is not maximised because there is underallocation of resources. This causes partial market failure. Hence, there is market failure which requires government intervention.
Asymmetric Information
Adverse Selection
Ex. Healthcare insurance market. One economic agent has more information than the other before a transaction is made, leading to the economic agent exploiting his position
Those who require the insurance are more likely to pay for it. However, there would be higher risks incurred by these insurance consumers since they require insurance more than others. This drives the prices of premium upwards.
The increase in insurance prices drives out healthy consumers. Society's welfare is not maximised because there is underallocation of resources as some people cannot obtain this healthcare insurance. This causes partial market failure. Hence, there is market failure which requires government intervention.
Moral Hazard
Ex. Healthcare insurance market. One economic agent has more information about their own actions after a transaction is made, leading to the economic agent engaging in riskier behaviour as the cost would not be borne by themselves
The insurance company cannot monitor the behaviours of the person who is buying insured. This may lead to consumers who have purchased insurance to engage in risky behaviour.
This leads to a loss of unfavourable outcome that would be paid by the insurance company. Society's welfare is not maximised because there is an overallocation of resources. This causes partial market failure. Hence, there is market failure which requires government intervention.
Presence of externalities
Market Dominance