• Topic Questions (MCQ – EASY): Market failure
• Topic Questions (MCQ – HARD): Market Failure

definition of market failure

• Market failure is a situation in which the free market fails to allocate goods and services efficiently, resulting in a suboptimal outcome.
• In other words, market failure occurs when the market mechanism does not lead to the most efficient use of resources, and may result in a misallocation of resources, overproduction or underproduction.

reasons for market failure

• Externalities
  • Externalities occur when the actions of one economic agent affect the welfare of others, either positively or negatively, without the corresponding compensation.
  • For example, pollution from a factory may harm the health of nearby residents without compensation, or a vaccine may reduce the spread of a disease and benefit the community as a whole without compensation.
  • Externalities can lead to inefficient outcomes, as the market may fail to take into account the full social costs or benefits of an activity.
• Information failure, Provision of Merit and Demerit Goods
  • Information failure occurs when market participants have incomplete or inaccurate information about the goods or services being traded.
  • Merit goods are goods and services that are deemed to be socially desirable and under-provided by the market, such as education and healthcare, while demerit goods are goods and services that are deemed to be socially undesirable and over-provided by the market, such as cigarettes and alcohol.
  • The market may fail to provide an optimal amount of these goods due to externalities, imperfect information, or irrational behavior.
• Provision of Public Goods
  • Public goods are goods and services that are non-excludable and non-rivalrous in consumption, such as national defense and street lighting.
  • These goods are typically provided by the government as the market may fail to provide them due to free-rider problems and the difficulty of excluding non-payers.
• Adverse Selection and Moral Hazard
  • Adverse selection occurs when one party in a transaction has better information than the other party, leading to inefficient outcomes. For example, insurance companies may face adverse selection if only high-risk individuals purchase insurance.
  • Moral hazard occurs when one party has an incentive to take excessive risks or shirk their responsibilities due to incomplete contracts or insufficient monitoring. For example, a bank may take on excessive risk knowing that the government will bail it out in the event of a crisis.
• Abuse of Market Power
  • Market power refers to the ability of a firm or group of firms to influence the price or quantity of a good or service in the market.
  • Abuse of market power occurs when firms use their market power to engage in anti-competitive behavior, such as price-fixing or exclusionary practices, leading to inefficient outcomes.