1.3.5 - Market failure

Market failure occurs when the price mechanism produces an inefficient allocation of resources. The market quantity is too high or too low compared with the socially optimal quantity, so total social welfare could be increased by changing output.

These sources can overlap. For example, asymmetric information in insurance can coexist with moral hazard, while speculative buying can help create a bubble. Keep the mechanisms distinct before explaining how they interact.

Marginal social benefit equals marginal private benefit plus marginal external benefit: $MSB = MPB + MEB$. If an action creates an external benefit, $MSB>MPB$.

Marginal social cost equals marginal private cost plus marginal external cost: $MSC = MPC + MEC$. With a negative production externality, $MSC>MPC$.

Classify an externality in two steps: identify whether production or consumption creates it, then identify a benefit or cost falling on a third party. The same good may create more than one externality at different stages.

Draw marginal cost and benefit on the vertical axis and quantity on the horizontal axis. The market equilibrium uses the private curves; the social optimum is where $MSB=MSC$. Mark both quantities, then identify the welfare triangle between the relevant social and private curves over the gap in output.

For a consumption external benefit, correcting underconsumption creates a welfare gain equal to the previously lost welfare. For a production external cost, reducing overproduction removes welfare loss.

A valid application names the decision-maker, the third party, the spillover and the resulting resource-allocation effect. Context alone does not prove an externality.

Test rivalry and excludability separately. A good is a pure public good only when it is both non-rival and non-excludable. Congestion, access charges or capacity limits can make a real-world example impure.

Because a public good is non-excludable, a person can receive its benefit without paying. Each person therefore has an incentive to wait for others to fund it. If many people free ride, a private supplier cannot reveal willingness to pay or collect enough revenue.

Expected revenue may not cover production cost, so profit-seeking firms provide too little or none of the good even when its total social benefit exceeds its social cost. This is non-provision or underprovision, a form of market failure.

Flood defences protect many residents at once. One resident's protection does not reduce another's, and excluding non-payers from the protected area may be impractical, so voluntary private payment is difficult to sustain.

An insurance applicant may know more about their health or driving risk than the insurer. Conversely, a provider may know more about a product's quality or limitations than the buyer.

An information gap exists when a decision-maker lacks relevant knowledge about benefits, costs, quality or risk. Choices then reflect perceived rather than actual private benefits and costs, so demand, supply and resource allocation may move away from the socially efficient outcome.

For each context, identify who lacks information, what decision changes, and whether resources are consequently over- or under-allocated. Do not jump from 'information is imperfect' directly to a conclusion without this chain.

Moral hazard occurs when protection from the consequences of an action changes behaviour, encouraging greater risk-taking or less care because another party bears some of the cost.

1. A contract, guarantee or expectation of rescue transfers part of a possible loss.
2. The protected party has less incentive to prevent that loss.
3. Behaviour becomes riskier after protection is available.
4. Insurers, lenders, governments or other parties face higher expected costs.

An insured driver may take less care because the insurer pays much of a covered loss. A bank expecting rescue if it fails may choose riskier lending because depositors, a guarantee fund or government absorbs part of the downside.

The impact depends on how much loss is transferred, monitoring, deductibles or capital at risk, the probability of rescue, and whether protecting the wider system prevents larger spillover costs.

A market bubble is a rapid or sustained rise in an asset price above a sustainable or fundamental value, often driven by speculation and expectations of further price increases.

1. An initial demand increase raises the asset price.
2. The rise attracts speculators expecting resale profit.
3. Easier credit, herd behaviour or overconfidence can add demand.
4. Higher demand confirms optimistic expectations and pushes price further from underlying value.
5. When credit, confidence or expectations reverse, demand can fall sharply and the bubble may burst.

Housing bubbles affect affordability, rents, mortgages, construction and banks. Stock-market bubbles affect household portfolios and firms' cost of raising finance. In both, early sellers may gain while buyers near the peak bear greater downside risk.

Judge impact using ownership rates, leverage, bubble size, exposure of banks and pension funds, policy response, and the time horizon. A correction is more damaging when debt is high and losses spread through credit and spending.