Market Failure and Its Causes

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What is market failure?

A situation in which the allocation of goods and services by a free market is not Pareto efficient

Which of the following is NOT a cause of market failure?

Competitive markets

What are some government policy interventions that may lead to an inefficient allocation of resources?

Taxes, subsidies, wage and price controls, and regulations

What is the Coase theorem?

Private transactions are efficient as long as property rights exist, only a small number of parties are involved, and transactions costs are low

What is the 'tragedy of the commons'?

The overutilization of an otherwise renewable resource at a point in time

What is anthropogenic global warming?

A 'tragedy of the commons'-type of ecological market failure

What is 'uneconomic growth'?

A pervasive ecological market failure that exceeds the immediate social benefits derived from further economic growth in a full-world economy

What is the second best theory?

When market failure occurs in one branch of the economy, it should be feasible to increase social welfare in another branch of the economy

What is Chang's criticism of market failure paradigm?

Government cannot always restore Pareto optimality because of insufficient knowledge, efficiency, and altruism

Study Notes

Market failure and its causes

  • Market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value.

  • Market failures are often associated with public goods, time-inconsistent preferences, information asymmetries, non-competitive markets, principal–agent problems, or externalities.

  • The existence of market failure is often the reason that self-regulatory organizations, governments or supra-national institutions intervene in a particular market.

  • Government policy interventions, such as taxes, subsidies, wage and price controls, and regulations, may also lead to an inefficient allocation of resources, sometimes called government failure.

  • Different economists have different views about what events are the sources of market failure.

  • Markets may have significant transaction costs, agency problems, or informational asymmetry. Such incomplete markets may result in economic inefficiency, but also have a possibility of improving efficiency through market, legal, and regulatory remedies.

  • Macroeconomic business cycles are a part of the market. They are characterized by constant downswings and upswings which influence economic activity.

  • Policies to prevent market failure are already commonly implemented in the economy.

  • Economists such as Milton Friedman from the Chicago school and others from the Public Choice school argue that market failure does not necessarily imply that the government should attempt to solve market failures.

  • Some advocates of laissez-faire capitalism, including many economists of the Austrian School, argue that there is no such phenomenon as "market failure".

  • Market failure can have significant negative impacts on the environment, such as pollution and overexploitation of natural resources.

  • The Coase theorem states that private transactions are efficient as long as property rights exist, only a small number of parties are involved, and transactions costs are low.Types and Examples of Market Failures

  • Inefficiency arises when individuals choose means inconsistent with their desired goals, leading to market failure.

  • Marxian economists argue that market failure is an inherent feature of any capitalist economy, unlike the mainstream economics concept of "abnormal" situations.

  • Ecological economics argues that externalities are a modus operandi of the market, not a market failure, and that the fair allocation of non-renewable resources is a market failure issue.

  • Another ecological market failure is the overutilization of an otherwise renewable resource at a point in time, known as the 'tragedy of the commons.'

  • Anthropogenic global warming is a 'tragedy of the commons'-type of ecological market failure that can be remedied through a carbon dioxide emission permits system.

  • 'Uneconomic growth' is a pervasive ecological market failure that exceeds the immediate social benefits derived from further economic growth in a full-world economy.

  • Chang's criticism of market failure paradigm states that government cannot always restore Pareto optimality because of insufficient knowledge, efficiency, and altruism.

  • The “second best” theory holds that when market failure occurs in one branch of the economy, it should be feasible to increase social welfare in another branch of the economy.

  • Market failures and externalities can arise whenever transaction costs arise, so government should focus on eliminating both transaction costs and costs of provision.

Test your knowledge on market failure and its causes with this informative quiz! Learn about the different types of market failures, such as public goods, information asymmetries, and externalities, and their impact on economic efficiency. Discover the various perspectives of economists on the role of government intervention in addressing market failure. Take this quiz to deepen your understanding of market inefficiencies and their implications for the environment and society.

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