1.3.1 Types of Market Failure

Question 1

What is market failure?

Answer 1

Market failure occurs when the allocation of resources in a free market results in an inefficient or socially undesirable outcome.
It indicates that the market, left to its own devices, fails to achieve an optimal allocation of goods and services.
Market failure often leads to underproduction, overproduction, or misallocation of resources.

Question 2

What are the types of market failure?

Answer 2

1. Externalities: unintended side effects of economic activities that affect third parties who are not part of the transaction. They can be positive (benefits) or negative (costs).
2. Under-Provision of Public Goods: Public goods are non-excludable and non-rivalrous, meaning that no one can be excluded from their benefits, and consumption by one does not reduce availability to others. Because individuals can benefit without paying, there is a tendency for these goods to be underprovided by the private market.
3. Information Gaps (Asymmetric Information): Information gaps arise when one party in a transaction has more or better information than the other party. This can lead to adverse selection and moral hazard problems.

Question 3

What are some examples of each type of market failure?

Answer 3

1. Externalities: Air Pollution from Cars – London (Negative Externality)
- Cost to driver (private): Fuel, tax, maintenance — approx. £0.50/mile
- External cost: Estimated at £0.62 per mile in urban areas (Source: DEFRA 2022), due to air pollution, congestion, and health effects.
- In 2019, air pollution in London was linked to over 4,000 premature deaths per year. NHS England estimates air pollution costs the health service £1.5 billion per year.
Policy Response:
- ULEZ charges (£12.50/day) aim to internalise the external cost.

2. Under-provision of a Public Good Street Lighting – UK
- A council estimates the cost of maintaining street lighting in a small town at £500,000 per year.
- Local residents benefit from improved safety, reducing crime and accidents:
- UK Home Office data: Improved lighting can reduce crime by up to 21% in some areas.
- However, no private firm provides this because:
- It is non-excludable — people can’t be charged directly.
- Free rider problem prevents voluntary funding.

3. Information Gaps A. Moral Hazard – UK Banking Crisis (2008)
- RBS bailout: UK government injected £45.5 billion into RBS to prevent collapse.
- Banks engaged in high-risk lending and investment because they believed they were “too big to fail”.
- Total UK bank bailout: Over £137 billion in direct support + £1 trillion in guarantees.
- Moral Hazard Effect: Banks knew they wouldn’t face the full cost of failure → took more risk than socially optimal.

B. Adverse Selection – US Health Insurance (Pre-ACA)
- Healthy individual’s expected annual cost: ~$500
- Unhealthy individual’s expected cost: ~$5,000
- Insurers, lacking full info, charged an average premium of ~$2,750
- Outcome: Healthy individuals left the market; pool became riskier → premiums rose
- Result: Before the ACA (2010), over 45 million Americans were uninsured. Adverse selection made private health insurance inefficient and unaffordable for many.