Market efficiencies and inefficiencies happen all around us. Consider the definition of perfect competition and give an example from your personal life.
This is an economic situation that really doesn't exist, in which a bunch of conditions are met, not the least of which are free entry and exit from a market, tons of sellers selling the exact same product, and tons of buyers for that product who have perfect knowledge of what it does and how it works. An Indian fish market might be an example of something close to this (though real "perfect competition" doesn't really exist.) At the fist market, lots of sellers gather together to try to sell the same wares, and lots of customers try to buy them with a good knowledge of what they are buying. There is little to prevent someone from joining in on the selling or quitting the market altogether.
Now, consider the four sources of market failure and examine how each led to an inefficient allocation of resources. Take a moment to look around you and give an example for each of the four sources of market failure. Why do you feel these are good examples?
The four types of market failures are public goods, market control, externalities, and imperfect information.
Public goods causes inefficiency because nonpayers cannot be excluded from consumption, which then prevents voluntary market exchanges. Common examples of public goods include national defense, public health and environmental quality. In each case consumption by one does not impose an opportunity cost on others and nonpayers cannot be excluded from consumption. And in each case, markets fail to efficiently allocate the production, consumption, or provision.
Market control occurs because limited competition among buyers or sellers prevents the equality between demand price and supply price. An extreme example of market control on the supply side exists withmonopoly, a market with a single seller. A less extreme, but more common example, isoligopoly, a market with a small number of large sellers.
Externalities prevent efficiency because external costs or benefits mean demand prices or supply prices do not fully reflect the value of goods produced or the value of goods not produced. A noted externality example ispollution. The emission of residuals in the production or consumption of goods impose opportunity costs on others not involved the market exchange. In this case the supply price in the market does not include all opportunity costs of production, the omitted costs are those imposed on others harmed by the pollution.
Imperfect information among buyers or sellers, like externalities, also means that demand prices or supply prices do not fully reflect the value of goods produced or the value of goods not produced.
In many cases, sellers have better information about a good that buyers. Sellers own and control the good, they have direct contact with the good. If there are defects or problems with the good, they are likely to know. Buyers, in contrast, have much less familarity with a good, perhaps only knowing the information provided by the sellers. In this case, buyers are likely to have a different demand price than the value of the good produced, a value based on more complete information.
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