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Market Failure

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Market Failure
• Definition:
• Where the market mechanism fails
to allocate resources efficiently
– Social Efficiency
– Allocative Efficiency
– Technical Efficiency
– Productive Efficiency

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Market Failure
• Social Efficiency = where external
costs and benefits are accounted for
• Allocative Efficiency = where society
produces goods and services at
minimum cost that are wanted by
consumers
• Technical Efficiency = production of
goods and services using the minimum
amount of resources
• Productive Efficiency = production of
goods and services at lowest factor cost

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Market Failure
• Allocative efficiency:
– Also referred to as
• Pareto Efficient Allocation –
resources cannot be readjusted
to make one consumer better off
without making another worse off
– zero opportunity cost!
– After Vilfredo Pareto (1848–1923)

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Market Failure
• Market Failure occurs where:
– Knowledge is not perfect - ignorance
– Goods are differentiated
– Resource immobility
– Market power
– Services/goods would or could not be
provided in sufficient quantity by the market
– Existence of external costs and benefits
– Inequality exists

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Market Failure
• Imperfect Knowledge:
– Consumers do not have adequate technical
knowledge
– Advertising can mislead or mis-inform
– Producers unaware of all opportunities
– Producers cannot accurately measure
productivity
– Decisions often based on past experience
rather than future knowledge

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Market Failure
• Goods/Services
are differentiated
– Branding
– Designer labels - they
cost three times as
much but are they
three times the
quality?
– Technology – lack of
understanding of the
impact
– Labelling and product
information Which one is the ‘quality’ item and why?

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Market Failure
• Resource Immobility
– Factors are not fully mobile
– Labour immobility – geographical and
occupational
– Capital immobility – what else can we
use the Channel Tunnel for?
– Land – cannot be moved to where it
might be needed, e.g. London and
South East!

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Market Failure
• Market Power:
– Existence of monopolies and
oligopolies
– Collusion
– Price fixing
– Abnormal profits
– Rigging of markets
– Barriers to entry

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Market Failure
• Inadequate Provision:
• Merit Goods and Public Goods
– Merit Goods – Could be provided by
the market but consumers may not
be able to afford or feel the need to
purchase – market would not provide
them in the quantities society needs
– Sports facilities?

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Market Failure
• Merit Goods
• Education –
nurseries,
schools, colleges,
universities –
could all be provided
by the market but
would everyone be
able to afford them?
Schools: Would you pay if the state
did not provide them?

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Market Failure
• Public Goods
– Markets would not
provide such goods and
services at all!
• Non-excludability –
Person paying for
the benefit cannot A non-excludable good?
prevent anyone else
from also benefiting -
the ‘free rider’
problem
• Non-rivalry –
Large external benefits
relative to cost –
socially desirable but not
profitable to supply!

Would you pay for this?

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Market Failure
• De-Merit Goods
• Goods which society over-produces
• Goods and services provided by
the market which are not in our
best interests!
– Tobacco and alcohol
– Drugs
– Gambling

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Market Failure
• External Costs and Benefits
• External or social costs
– The cost of an economic decision to a
third party
• External benefits
– The benefits to a third party as a
result of a decision by another party

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Market Failure
• External Costs
• Decision makers do not
take into account the
cost imposed on society
and others as a result of
their decision
– e.g. pollution, traffic
congestion,
environmental
degradation, depletion
of the ozone layer,
misuse of alcohol,
tobacco, anti-social
behaviour, drug abuse,
poor housing

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External Costs
MSC = MPC + External Cost
Price The Marginal Social Benefit
The
TheThe MPC
truedifference
cost doesbetween
therefore not is
take
thetheinto
MSC
curve (MSB) represents the
MPC account
(thevalue
MPC plusthe
sum of the MSB thecost to society
external
benefits cost).
andtothe MSC of
production.
Current output the
represents At
levelsan output
therefore level
(100)
consumers in welfare
society loss
as a to
of
represent100, the
some private
element cost
of to
marketthe
£12 society
whole of
supplier
failure – price
100private
– the
is £5
does
units being
per
and social
notunit but the
accurately
produced.
benefits. The Marginal
cost
reflect thetotrue
society
cost is
ofhigher than
production.
Private Cost (MPC) curve
this (£12).
Value ofrepresents
the negative
the costs to

£7 Social Cost suppliers of producing a

externality (Welfare Loss)
given output.

£5 Socially efficient output is where

MSC = MSB

MSB

80 100 Quantity Bought and Sold

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Market Failure
• External benefits –
– by products of
production and
decision making that
raise the welfare of a
third party
– e.g. education and
training, public
transport, health
education and
preventative medicine,
refuse collection,
investment in housing
maintenance, law and
order

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External Benefits
Price There can be a position
where output is less than
would be socially desirable
(education for example?) In
MSC this case, the sum of the
benefits to society is greater

£10 Value ofthan the private benefit to the

the
individual.
positive
externality (Welfare Loss)
Social Benefits
£6.50
Socially efficient output
£5
is where
MSC = MSB
MSB

MPB
100 140
Quantity Bought and Sold

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Market Failure
• Inequality:
– Poverty – absolute and relative
– Distribution of factor ownership
– Distribution of income
– Wealth distribution
– Discrimination
– Housing

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Market Failure
• Measures to correct market
failure
– State provision
– Extension of property rights
– Taxation
– Subsidies
– Regulation
– Prohibition
– Positive discrimination
– Redistribution of income

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