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Market Failure versus Government Failure

Learning Objectives


  1. Explain what an externality is and show how it affects the market outcome.

  2. Describe three methods of dealing with externalities.

  3. Define public good and explain the problem with determining the value of a public good to society.

  4. Explain how informational problems can lead to market failure.

  5. List five reasons why government's solution to a market failure could worsen the situation.

Chapter Summary

Market failure refers to market outcomes failing to result in socially optimal outcomes. Three sources of market failure are externalities, public goods, and imperfect information. An externality occurs when costs or benefits associated with the production or consumption of a good fall outside the market. The problem associated with a public good is that it is difficult to determine its value. When buyers and sellers have different amounts of information, adverse selection can occur. Any time a market failure exists there is a reason for possible government intervention to improve the outcome.

However, it is always possible that government intervention in the market meant to improve the market failure may actually make matters worse. This is referred to as government failure. Economic policy is often a choice between market failure and government failure. An optimal policy is always one that equates marginal benefits and marginal costs.

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