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AS Market Failure

Market Failure

When markets do not provide us with the best outcome in terms of efficiency and fairness, then we say that there exists market failure. This brief chapter introduces us to some of the main causes of market failure; we will explore them in more detail in succeeding chapters.

What is market failure?

Market failure occurs whenever freely-functioning markets operating without government intervention, fail to deliver an efficient allocation of resources and the result is a loss of economic and social welfare. Market failure exists when the competitive outcome of markets is not satisfactory from the point of view of society. This is usually because the benefits that the free-market confers on individuals or businesses carrying out an activity diverge from the benefits to society as a whole.

One useful distinction is between complete market failure when the market simply does not exist to supply products at all (i.e. we see “missing markets”), and partial market failure, when the market does actually function but it produces the wrong quantity of a good or service at the wrong price.

Markets can fail for lots of reasons and the main causes of market failure are summarized below:

Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost
Positive externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit
Imperfect information means merit goods are under-produced while demerit goods are over-produced or over-consumed
The private sector in a free-markets cannot profitably supply to consumers pure public goods and quasi-public goods that are needed to meet people’s needs and wants
Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition
Factor immobility causes unemployment hence productive inefficiency
Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and consequent social exclusion which the government may choose to change

Market failure and economic efficiency
When markets function well we experience an efficient and fair (equitable) allocation of resources
Market failure results in

Productive inefficiency: Businesses are not maximising output from given factor inputs. This is a problem because the lost output from inefficient production could have been used to satisfy more wants and needs. Costs are higher and productivity is lower than it might have been.
Allocative inefficiency: Resources are misallocated and the economy is producing goods and services that are not wanted or not valued by consumers. This is a problem because resources might be put to a better use making products that we value more highly. Allocative efficiency is the most relevant concept that you can use at AS level to analyse and evaluate market failure.

Author: Geoff Riley, Eton College, September 2006

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AS Market Failure

Market Failure

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