Question

How do market failures cause inefficient allocations of resources? Be sure to understand common market failure problems that apply to the environment like externalities, public goods, imperfect competition, and asymmetric information issues. Understand why government failures can occur along similar lines in some cases

Answer 1

There are various situations under which market is not Pareto efficient and leads to market failure.

In case of imperfect competition, average cost keeps on declining and charging price les than average cost leads to continued losses. Hence no competitive firm will be willing to produce these goods abd government has to intervene. Imperfect competition creates deadweight loss in the economy.

Public goods are the goods which are non rival in consumption and non exclusive. Even if these goods are supplied by the market they will be supplied in inefficient quantity. For example national defense. Market failure occurs due to free rider problem.

Externalities are the actions of one individual which create cost or benefits for others. It can be either positive or negative externalities. Since individuals don’t bear the full cost of externalities they overproduce in case of negative externalities and underproduce in case of positive externalities.

Information is like public good. Efficiency requires information to be freely provided. But there is cost of acquiring information. For example research and development. In case of asymmetric information value to buyers may be more than cost to the sellers and coordination between the two are not met. Thus market failure arises.