Name two types of market failure (with examples). Explain why each may cause market outcomes to be inefficient
inefficiency -markets may fail to produce and allocate scarce resources in the most efficient way
incomplete markets -markets may fail to produce enough merit goods such as education and health care
Two types of market failure are externalities and market power.
1. Externalities:
Externalities occur when the production or consumption of a good or service affects parties other than the buyer or seller, leading to costs or benefits that are not reflected in the market price. Externalities can be positive or negative.
Example: Pollution is a negative externality. When a factory produces goods, it may release pollutants into the air, causing harm to the environment and people nearby. The costs associated with pollution, such as increased healthcare expenses or damage to ecosystems, are borne by society as a whole, not just the factory or its customers.
Inefficiency: In the presence of negative externalities, market outcomes tend to be inefficient. The market fails to account for the social costs associated with activities like pollution, resulting in an overproduction or overconsumption of goods that generate negative externalities. This leads to an inefficient allocation of resources as goods with negative externalities may be produced and consumed at levels greater than the socially optimal level.
2. Market Power:
Market power refers to the ability of a firm or a group of firms to influence the market price or quantity of a product. When a firm has market power, it can limit competition and manipulate prices or output to its advantage.
Example: Monopolies are a classic example of market power. When a single firm dominates a particular market, it can set prices higher than the competitive level due to lack of competition. This enables the monopoly to earn excessive profits at the expense of consumers.
Inefficiency: Market power leads to market outcomes that are inefficient. The lack of competition reduces the incentive for firms to be efficient, innovate, or offer competitive prices. As a result, consumers may face higher prices, lower quality products, and limited choices. The existence of market power usually leads to a misallocation of resources, with the monopolistic firm producing too little output at higher prices compared to a competitive market equilibrium.
In both cases, externalities and market power, the market outcomes deviate from the socially optimal level, resulting in inefficiency and the potential need for government intervention or corrective measures.