Answer to Question #320902 in Economics of Enterprise for kara

Question

A market failure occurs when there is an inefficient allocation of resources. In other words, the true cost of a good is not reflected in the price. This might be because of a third-party benefit but does not pay for that benefit. Or, it could arise due to a cost that is imposed on a third party without their consent and compensation. In turn, this leads to an inefficient allocation of resources as a third party may bear the cost or benefit. There are many causes of market failure which range from externalities to inefficient supply. The inefficient allocation of resources is not just limited to the supply of goods. Market failure can also occur through externalities. This can be both positive and negative

Propose and analyze any four causes of market failure.

Answer 1

Causes of market failure include:

Market control - a monopoly lacks competition in the market and thus dictates prices and supply. This can often lead to diseconomies of scale and other inefficiencies. A monopoly thus produces an inefficient allocation of resources.

Lack of information - customers may not have enough information on all the factors informing pricing of a final product. Therefore, the true value is not aligned to price, leading to inefficient allocation of resources.

Externalities - Negative externalities such as traffic and pollution impose a cost onto a third party without consent or compensation but are not incorporated into the final price, thus causing a market failure. Positive externalities such as education have external benefit but also impose a cost on the taxpayer, inferring resources are inefficiently allocated.

Public goods - public goods pose an external benefit to all third parties, and private individuals may not consider this in the final price. This entails goods that provide social benefit that is not considered in the final cost. As third parties continue to use a merit good but do not pay for it, e.g. through taxes, this can cause market failure.