Market failure

For the price mechanism to allocate resources efficiently

Assumptions need to be made

Assumption 1

Individual market participants must not be able to influence the price

This means that there is no monopoly power

Assumption 2

Market participants must adopt maximising behaviour

For example consumers will act to maximise their own utility and firms will act to maximise profits 

Assumption 3 

There are no externalities associated with the production or consumption of the product

Assumption 4

Perfect information to all market participants

For example consumers know about all the alternatives available for them when they spend their limited income

Assumption 5

Resources are perfectly mobile between competing uses so that they can be reallocated to other products when market forces cause changes in the relative prices of goods

If any of these conditions are not satisfied 

Then market failure will result 

Market failure

Occurs when the price mechanism of the free market fails to allocate scarce resources efficiently

Partial market failure

The market exists but there is over production or underproduction of the good or service

Complete market failure 

The market simply does not supply products at all 

We see missing markets 

Market can fail for lots of reasons

Public goods

Existence of externalities

Merit and demerit goods

Absence of property rights

Imperfect information

Monopoly power

Volatile prices

Income inequality