Notes on market
failures
Economists use the term market failure to describe real world situations in which unfettered market forces misallocate scarce resources or fail to price items such as air, water, or public health and safety commensurate with their intrinsic worth. Public regulation of private production, consumption, or exchange has the potential to improve social welfare if it provides remediation for a market failure. Market failures arise from the following factors:
| Imperfectly competitive market structures: Market power (i.e., power over price) possessed by buyers or sellers produces economically sub-optimal prices and quantities for goods and services. |
| Externalities or spillovers: Private production or consumption imposes costs on third parties (i.e. those neither on the demand or supply side of a market transaction) who receive no compensation. “External” costs—i.e. those borne by third parties, are not reflected in market prices. Example: Acid rain produced by coal-fired power plants in Ohio hurts the fishing industry Pennsylvania, upstate NY, and Ontario. |
| Inadequate buyer knowledge/informational asymmetries: Lack of information may prevent consumers from purchasing their “optimal” commodity bundle—i.e., the bundle of goods and services that maximizes their utility subject to the budget constraint. A used car salesman may have better information about the quality of a car than the buyer; therefore, the transaction price diverges from that which would prevail if both parties had perfect information. |