Explain the main sources of market failure and evaluate government policies used to correct them.

What this dot point is asking

A market fails when the free-market quantity differs from the quantity that maximises society's wellbeing. The main sources examined in TCE Economics are externalities, public goods, common access resources, information failure and market power.

Externalities

An externality is a cost or benefit that falls on a third party who is not part of the transaction.

• A negative externality (such as factory pollution) means the social cost is greater than the private cost. The market overproduces because producers ignore the cost imposed on others. On a diagram, the marginal social cost curve sits above the marginal private cost curve, and the efficient quantity is lower than the market quantity.
• A positive externality (such as vaccination or education) means the social benefit is greater than the private benefit. The market underproduces because buyers ignore the benefit to others.

The deadweight loss is the loss of welfare from producing the wrong quantity. Government policy aims to internalise the externality so that decision-makers face the full social cost or benefit.

Public goods

Public goods are non-excludable (you cannot stop non-payers using them) and non-rival (one person's use does not reduce another's). Examples include national defence and street lighting. Because of the free-rider problem, private firms cannot profitably supply them, so the market provides too little or none. Government usually provides public goods directly, funded by taxation.

Common access resources

Common access resources, such as fish stocks or clean air, are rival but non-excludable. Without rules they tend to be over-used, an outcome often called the tragedy of the commons. Australian examples include managed fisheries, where the government sets catch quotas to prevent depletion.

Information failure and market power

• Asymmetric information occurs when one party knows more than the other, for example a used-car seller. This can lead to poor decisions and under-trading of good products.
• Market power, such as a monopoly, allows a firm to restrict output and raise price above the competitive level, creating allocative inefficiency.

Government responses

Governments have several tools, each with strengths and weaknesses.

• Indirect taxes raise the private cost of a good with negative externalities, shifting supply left and reducing output toward the efficient level. Australia's tobacco excise is a clear example.
• Subsidies lower costs for goods with positive externalities, shifting supply right and raising output, for example subsidies for vaccination or renewable energy.
• Regulation sets legal rules, such as emission limits, fishing quotas or minimum standards.
• Direct provision supplies public goods such as defence and public health.
• Tradable permits cap total pollution and let firms trade the right to emit, using the market to find the cheapest reductions.
• Education and information campaigns correct information failure.

In evaluation questions, identify the failure, recommend a policy, explain how it changes the diagram, and then weigh up its costs, benefits and the risk of government failure.