Market Failure

Definition of Market Failure This occurs when there is an inefficient allocation of resources in a free market. Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less output), negative externalities (over-consumed) and public goods (usually not provided in a free market)

Types of market failure:

1. Positive externalities – Goods/services which give benefit to a third party, e.g. less congestion from cycling
2. Negative externalities – Goods/services which impose cost on a third party, e.g. cancer from passive smoking
3. Merit goods – People underestimate the benefit of good, e.g. education
4. Demerit goods – People underestimate the costs of good, e.g. smoking
5. Public Goods – Goods which are non-rival and non-excludable – e.g. police, national defence.
6. Monopoly Power – when a firm controls the market and can set higher prices.
7. Inequality – unfair distribution of resources in free market
8. Factor Immobility – E.g. geographical / occupational immobility
9. Agriculture – Agriculture is often subject to market failure – due to volatile prices and externalities.
10. Information failure – where there is a lack of information to make an informed choice.
11. Principal-agent problem – Two agents with different objectives and information asymmetries

 

Key Terms in Market Failure

• Externalities:  These occur when a third party is affected by the decisions and actions of others.
• Social benefit:  the total benefit to society =
  Private Marginal Benefit (PMB) + External Marginal  Benefit (XMB)
• Social Cost: is the total cost to society =
  Private Marginal Cost (PMC) + External Marginal Cost (XMC
• Social Efficiency: This occurs when resources are utilised in the most efficient way. This will occur at an output where social marginal cost (SMC) = Social Marginal Benefit. (SMB)

 

Overcoming Market Failure

• Tax on Negative Externalities – e.g. Petrol tax
• Carbon Tax e.g. tax on CO2 emissions
• Subsidy on positive externalities – why government may subsidies public transport
• Laws and Regulations – Simple and effective ways to regulate demerit goods, like a ban on smoking advertising.
• Buffer stocks – aim to stabilise prices
• Government failure – why government intervention may not always improve the situation