Market Failure

Free market Economy

A Society which solely relies on

 Free market mechanism

 Market forces of demand and supply to allocate resources
o To allow free market economy to function automatically

Advantages
 No need for costly and complex bureaucracy to make decisions
 Assuming P.C and no M.F, free market leads to allocative efficiency,
o At market equilibrium, Marginal Social Benefit of producing last unit will equal
Marginal Social Cost of producing last unit (MSB=MSC)
 Producer and Consumer surpluses are maximised
 Allocative Efficiency

C.s

P.s

Free market maximizes P.s + C.s

 Competition between firms

 profit motive acts as incentive for firms to be productively efficient

Disadvantages

1) Market failure  free market fails to allocate resources in an optimum and efficient manner
Due to :
o Externalities
o Merit/Demerit goods
o Public goods (market fails to supply certain goods)
o Imperfect competition (market creates firms with strong market power)
o Imperfect Information
o Immobility of Factors of Production
2) Free market  income inequality
o Free market responds to “dollar votes” by Crs
o Economic agents with wealth will dictate the market
o Resources allocated to production of goods DD by the rich (at the expense of basic
Goods)
o Societal welfare not maximised
3) Free market  Macroeconomic Instability
o Economic decisions based on self-interest, Crs may tend to over/underspend
o Periods of recession and inflation
Sources of Market Failure
Externalities

o 3rd party effects arising from pursuit of self-interest

o Occurs when costs of benefits of production/consumption ‘spills over’ on to third parties
o Creates divergence between Private and Social Costs/Benefits
o Due to Pursuit of self-interest
o Only consider private cost/benefit
o Ignore societal cost/benefit
o Over-produce goods with –ve externality/ Under-produce goods with +ve externality

How to explain externalities in externality graphs

10 points to be explained (-ve from production)

1) Costs/Benefits, Y axis
2) Quantity of good, X axis
3) MPC of producing a good
4) MEC  explain all external costs ( in some cases MEC  as output  e.g. pollution)
5) MSC = MPC + MEC
6) MPB = MSB, the Demand curve
7) Free market Equilibrium Output, Ofm where MPC = MPB
8) But MSC > MSB, Socially optimal level of production Os at MSC = MSB
9) Free market  overproduction of goods (too much being prod for the good of Society)
10) Deadweight loss (welfare loss as a result of (9))

10 points to be explained (+ve from consumption)

1) Cost/Benefits, Y axis
2) Quantity of good, X axis (e.g. Education)
3) MPB
4) MEB  explain external benefits to society
5) MSB = MPB + MEB
6) MPC = MSC , the Supply curve
7) Free market Equilibrium Output, Ofm where MPB = MPC
8) But MSB > MSC, Socially optimal level of production Os at MSC = MSB
9) Free market  underproduction of goods (too little resources alloc for prod of good)
10) Deadweight loss (society loses net benefit it stands to gain)
Demerit/Merit Goods
A difference in DD curve

Demerit Goods Merit Goods

Goods that government perceives as bad for the Goods that government thinks are good for the
individual consuming them individual consuming them
Eg. Drugs, alcohol Eg. Education, Vaccinations

Negative externality argument Positive externality argument

Consumption  third party effects  Consumption  societal benefits  under-
overconsumption  welfare loss consumption  society loses out

Imperfect info argument Imperfect info argument

Imperfect info about costs/benefits  Imperfect info about costs/benefits 
Individuals underestimate personal costs (e.g. Individuals undervalue personal benefits(e.g.
health effects)  Over-consume good health gains)  Under-consume good

Poor judgment Poor judgment

Individuals do not act in their best interests due to Individuals do not act in their best interests due to
lack of poor judgement  Overconsumption lack of poor judgement  Under-consumption

Public Goods
Goods that will not be produced if left to the free market due to non-rivalry and non-excludability

o Non-rivalry
o non-diminishable in consumption
o benefits not depleted by an additional user of the good
o Non - Excludability
o Goods such, as military defence, cannot be denied to those who refuse to pay for
them.
o Once a good is provided, non-payer cannot be prevented from using the good
(free-rider problem)
o No one has the incentive to pay for the good
o No firm will produce them

Imperfect Competition
Allocative Inefficiency

o Explain why imperfect competition firms are allocative inefficient (MC=MR  P > MC)

Productive Inefficiency

o Explain why imperfect competition firms are productively inefficient (not at LRAC)
o MPC  normal profits in long run  always prod inefficient
(oligopoly and Monopoly by chance only)
Imperfect Information
Ignorance arising from lack of or inaccurate information

o Merit demerit goods

o Imperfect info from imperfect competition
firms/Crs have imperfect knowledge misallocation of resources  inefficiency
o Persuasive advertising
 Mislead people/oversell products  higher than socially optimal consumption

Immobility of factors of production

Factor inputs may be slow to respond to changes in DD and SS

 Occupational immobility
o Barriers to the mobility of F.O.P
o Mismatch between skills on offer from the unemployed and those required from
employers
o F.O.P remain unemployed, underemployed  market failure
 Geographical Immobility
o Barriers in moving factors from one place to another
o Reasons
 Family and social ties
 Financial costs in moving
 Regional variations in house prices
 Differences in costs of living
o Discourages labour from moving into areas with shortage
o Perpetuate high unemployment in other areas
o Unemployment  loss in output (potential)
o Wastage of resources market failure