Market Faliure

What are scare resources most of the time?

Factors of production

What is market failure?

When there is a less than optimum allocation of resources from the point of view of society

From society’s point of view, market failure occurs when there is lack of efficiency in the allocation of resources

When does a complete market faliure occur?

When there is a missing market.

The market does not supply products at all despite society having demand for it.

When does partial market failure occur?

Where the market exists, but does not provide resources in the optimum quantities.

There is an over production/consumption or under production/consumption of a good or service

Why are Public Goods a cause of market failure?

Public Goods are beneficial to society but would be under-provided by a free market, e.g. flood defences - because it is not profitable to a private company, and leads to the freerider problem.

Why do Negative Externalities a cause for market failure?

A negative externality occurs when a transaction imposes a cost on a third party who wasn't involved in the deal.

• The Example: A factory produces steel. To keep prices low, they dump toxic waste into a nearby river.

• The "Broken Signal": The factory only pays for labor and raw materials. They don't pay for the dead fish, the sick villagers, or the ruined water supply.

• The Failure: Because the steel is "artificially" cheap (since the environmental cost is ignored), people buy more of it than they should. The market over-provides a harmful product.

Market failure happens because:

Social Cost ≠ Private Cost

Why do Positive Externalities cause market faliure?

A positive externality occurs when a transaction provides a benefit to a third party.

• The Example: You pay to get a flu vaccine.

• The "Broken Signal": You pay for your own protection. However, by getting the shot, you also protect your coworkers because you won't spread the virus to them. You aren't "paid" for the benefit you give to your coworkers.

• The Failure: Because individuals only look at their personal benefit—and not the total benefit to society—fewer people get vaccinated than is socially optimal. The market under-provides a beneficial service.

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Market failure happens because:

Social Benefit ≠ Private Benefit

Why Does the Tragedy Of The Commons lead to market failure?

The tragedy of the commons occurs when common pool resources (Rivalrous but Non-excludable resources) are used by either the producer or consumer in a way that is not sustainable

The "Tragedy" occurs because individuals act logically to maximize their own benefit, but in doing so, they destroy the resource for everyone.

Imagine a village has a "common" field where anyone can graze their cows for free.

1. The Individual Logic: A farmer thinks, "If I add one more cow to the field, I get 100% of the profit from that cow, but the 'cost' of the overgrazed grass is shared by the whole village."

2. The Chain Reaction: Every other farmer follows the same logic. They all add "just one more cow" to maximize their own wealth.

3. The Outcome: The grass is eaten faster than it can grow back. The field turns to dust, the cows starve, and the entire village loses its livelihood.

The market failed because it couldn't stop people from over-consuming a finite resource.

Why do Merit & demerit goods cause market failure?

These goods can be provided by the market, but the market produces the wrong quantity because consumers don't fully understand (or they ignore) the long-term effects on themselves and others.

Merit Goods (Under-consumed)

Merit goods are products that are better for a person than they realize. They provide more benefit to the consumer than the consumer "perceives" at the time of purchase.

• The Problem: Individuals often focus on short-term costs rather than long-term gains.

• The Example: Education. A student might see the short-term cost (effort, time, tuition) and decide not to study. However, education has massive long-term benefits for the individual (higher wages) and society (a more skilled workforce).

• Market Failure: Because people undervalue the benefit, the free market will under-provide education.

Demerit Goods (Over-consumed)

Demerit goods are products that are worse for a person than they realize. They are often addictive or have "hidden" long-term health costs.

• The Problem: Consumers suffer from information gaps. They might ignore the long-term risk of cancer or heart disease because they enjoy the immediate "buzz" or "hit."

• The Example: Cigarettes or Sugary Drinks. A person might buy a soda because it's cheap and tastes good, ignoring the future cost of dental bills or diabetes.

• Market Failure: Because people ignore the long-term harm, the free market will over-provide these goods.

What are the three types of market imperfections and what are they?

Imperfect Information - when buyers and sellers have different levels of information in a market

Monopoly/monopoly power - a large business which dominates a market

Factor immobility - when factors of production are unlikely to be perfectly mobile / cannot be easily relocated

Why do Market Imperfections cause market faliure?

1. Imperfect Information (Asymmetric Information)

Market failure occurs here because the "price signal" is dishonest. For a market to work, both parties need to know exactly what they are trading.

• The Problem: When one side knows more than the other (Asymmetric Information), they can exploit that gap.

• The Outcome: This leads to Adverse Selection (buying a "lemon" car because the seller hid the engine problems) or Moral Hazard (taking extra risks because you know your insurance will cover it).

• Why it's a failure: Resources are wasted on low-quality goods, or beneficial trades never happen because people are too afraid of being cheated.

2. Monopoly Power

In a perfect market, firms are "price takers"—they have to accept the market price. A monopoly is a "price maker."

• The Problem: Because a monopoly has no significant competition, it doesn't have to worry about losing customers to a cheaper rival.

• The Outcome: To maximize profit, a monopoly will intentionally restrict output and raise prices.

• Why it's a failure: The market produces less than what society wants and charges more than it costs to make. This creates Deadweight Loss, where some people who would have bought the product at a fair price are priced out, even though the firm could have produced it for them at a profit.

3. Factor Immobility

For a market to be efficient, "Factors of Production" (Land, Labor, Capital, and Enterprise) need to move to where they are most needed. When they can't, the market gets "stuck."

There are two main types of immobility:

• Geographical Immobility: Jobs are available in London, but workers are stuck in Manchester because they can't afford the move or have family ties. The "market for labor" fails to clear.

• Occupational Immobility: A coal mine closes, and there is a huge demand for software engineers. However, the miners can't instantly become coders.

• Why it's a failure: You end up with structural unemployment (wasted labor) in one area and shortages (unmet demand) in another. The economy is producing less than its maximum potential.

Why can Unequal distribution of income and wealth lead to market faliure?

1. Misallocation of Resources (Luxuries vs. Necessities)

In a market economy, producers follow the money. If 1% of the population has 90% of the wealth, the market will prioritize their desires over the basic survival of everyone else.

• The Problem: A developer might choose to build luxury penthouses that sit empty for most of the year because the profit margin is high, while there is a massive shortage of affordable housing for workers.

• The Failure: Resources (land, labor, steel) are funneled into "luxury" goods for the wealthy while "essential" goods for the poor are under-produced. From a social welfare perspective, this is an inefficient use of a nation’s limited resources.

2. Under-utilization of Human Capital

If wealth is concentrated at the top, a huge portion of the population lacks access to the tools they need to be productive.

• The Problem: Brilliant children born into low-income families may not be able to afford high-quality nutrition, healthcare, or university tuition.

• The Failure: This leads to Factor Immobility (specifically labor). The economy misses out on the potential doctors, engineers, and entrepreneurs who were "priced out" of developing their skills. This lowers the entire country's productive capacity.

3. The "Voice" Problem (Effective Demand)

The market "listens" to consumers through their spending. In a perfectly equal world, everyone has a vote on what should be produced.

• The Reality: In an unequal society, the wealthy have thousands of "votes" while the poor have almost none.

• The Result: The price mechanism fails to reflect the true preferences of the entire population. It only reflects the preferences of those with high purchasing power.