Question

Explain the concept of market failure. Give an example of a government policy or action to deal with market failure

Answer 1

Market failure refers to failure of competitive market to allocate resources efficiently or distribute goods efficiently. In the case of market failure, pareto optimality conditions are not satisfied. Causes of market failure:

a) Externalities: These can be defined as an impact of production and consumption of products affecting the third party. Externalities can be either positive or negative.

b) Public good: It is a good which are non-rival and non-exclusive in nature. Non-rival means consumption of the public good by one person does not reduce its amount available for the other person. For example National defense, public park, street light etc. Non-exclusion means if public good has been provided then it does not possible to exclude one person from consuming it.

c) Asymmetry Information: It deals with the study of decisions in transactions, wherein one party has access to more or better information than others. Due to information asymmetry, the following two problems occur:

(i) Adverse selection: This implies taking the advantage of asymmetric information before transaction. For example, a person may be more eager to purchase life insurance due to health problems than, someone who is healthy.

(ii) Moral hazards: This implies taking the advantage of asymmetric information after transaction. For example, if someone has car insurance he may commit theft by getting his car stolen to reap the benefits of the insurance.

Moral hazard refers to situation where one side of market cannot observe action of the other. For this reason it is sometimes called hidden action problem.

Signaling:

In order to overcome problem of adverse selection signaling is used by which one side of market provide information to the other side of market. For example: Plum owner can offer warranty and by providing warranty they signal to the buyer that they are not purchasing lemon. Similarly, in labor market a person may signal to the employer about higher productivity. For this purpose we provide information about level of education.

In order to indicate better productivity, a person indicates about his education but acquiring education involves cost. So, a person will prefer to get education and incur a cost if by incurring cost he is able to separate himself from others. This type of signaling is called separating equilibrium because it involves each type of worker is making a choice that allow him to separate himself from others.