Question

What is meant by market failure and discuss the main forms of market failure in an economy?

Answer 1

Market failure is such an economic situation or phenomena where there is inefficieny prevalent in free market allocation of goods and services . The individual incentives for rational behavior do not lead to rational outcomes for the whole economy or market . Price mechanism fails , which creates dead weight loss of economic welfare .

The major types of market failure are described below :

a) Monopoly : This is also defined as market concentration when one producer or just a small group of producer share all the market power and take price making decisions . Under a monopoly, the producer will produce too little or poor quality goods or services while pricing them above marginal cost , so the market fails .

b) Public good : They are non rival and non excludable in consumption . Public goods suffers from free rider problem , so they are under produced in free market . This leads to market failure .

c) Externalities : Externaities are spillover effect of production or consumption . This cannot be internalized in free market , so social output is not reached , hence causing a market failure , as for example education has positive externality which is underproduced in free market .

d) Information asymmetry : A very good example is market for lemons ( sell of used cars ) . When either seller or buyer has less information regarding the product , this causes market failure .