Question

What is the market failure? What are the types of market failure and how they work? Is it possible to prevent market failures? How?

(You are expected to give very detailed answer and example for each part of this question).

Answer 1

Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market. Furthermore, the individual incentives for rational behavior do not lead to rational outcomes for the group. Put another way, each individual makes the correct decision for him/herself, but those prove to be the wrong decisions for the group. In traditional microeconomics, this is shown as a steady state disequilibrium in which the quantity supplied does not equal the quantity demanded .

Types of market failure

1. Positive externalities – Goods/services which give benefit to a third party, e.g. less congestion from cycling.
2. Negative externalities – Goods/services which impose a cost on a third party, e.g. cancer from passive smoking.
3. Merit goods – People underestimate the benefit of good, e.g. education. It may also have positive externalities
4. Demerit goods – People underestimate the costs of a good, e.g. smoking. It may also have negative externalities.
5. Public Goods – Goods which are non-rival and non-excludable – e.g. police, national defence. Public goods are often not provided in a free market.
6. Monopoly Power – when a firm controls the market (with high market share) and can set higher prices.

In order to eliminate market failures, several remedies can be implemented. They include:

1. Use of legislation

One of the ways that governments can manage market failures is by implementing legislation that changes behavior. For example, the government can ban cars from operating in city centers, or impose high penalties to businesses that sell alcohol to underage children, since the measures control unwanted behaviors.

2. Price mechanism

Price mechanisms are designed to change the behavior of both the consumers and producers. For products that cause harm to consumers, the government can discourage their consumption by increasing taxes. For example, taxes on cigarettes and alcohol are periodically increased to discourage their consumption and reduce their harmful effects on unrelated third parties.