When markets misallocate resources: externalities, public goods, and merit and demerit goods.
Market failure occurs when the free market fails to allocate resources efficiently.
Externalities
An externality is a cost or benefit to a third party not involved in the transaction.
- Negative externalities (e.g. pollution): social cost > private cost, so the market overproduces.
- Positive externalities (e.g. education): social benefit > private benefit, so the market underproduces.
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