5a. Market failure
The meaning of market failure
Market failure occurs when the free market, left alone, fails to deliver an efficient allocation of resources. The result is a loss of economic and social welfare.
In some markets there is partial failure, where there is over or under the production of goods and services.
In other cases, there is complete market failure where markets fail to lead to any production of goods/services (a missing market e.g. defense).
Markets can fail because of :
Lack of competition in a market. Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition.
Negative externalities (e.g. the effects of environmental pollution) cause the social cost of production to exceed the private cost.
Positive externalities (e.g. the provision of education) cause the social benefit of consumption to exceed the private benefit.
Information failure – consumers may not have enough information to make the best decision e.g. if a dentist recommends further treatment but the patient is not in pain, how does the patient know if the treatment is really necessary?
Missing markets - the private sector in free markets being unable to supply important pure public goods e.g. street lighting and quasi-public goods profitably to consumers.
Immobility of factors of production causes unemployment and therefore productive inefficiency.
Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and subsequent social exclusion that the government may wish to correct.
Markets and the functions of price
Market failure can also occur when one or more of the three functions of prices break down.
Signaling function of prices breaks down in the case of externalities since the full costs and benefits of market transactions are not taken into account (included in the price).
Incentive function – monopolies often charge high prices, which should create an incentive for other firms to enter the market but significant barriers to entry often exist.
Rationing effect – current high prices of petrol should lead to a considerable rationing effect and reduced consumption but this does not appear to be the case.
The meaning of market failure
Market failure occurs when the free market, left alone, fails to deliver an efficient allocation of resources. The result is a loss of economic and social welfare.
In some markets there is partial failure, where there is over or under the production of goods and services.
In other cases, there is complete market failure where markets fail to lead to any production of goods/services (a missing market e.g. defense).
Markets can fail because of :
Lack of competition in a market. Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition.
Negative externalities (e.g. the effects of environmental pollution) cause the social cost of production to exceed the private cost.
Positive externalities (e.g. the provision of education) cause the social benefit of consumption to exceed the private benefit.
Information failure – consumers may not have enough information to make the best decision e.g. if a dentist recommends further treatment but the patient is not in pain, how does the patient know if the treatment is really necessary?
Missing markets - the private sector in free markets being unable to supply important pure public goods e.g. street lighting and quasi-public goods profitably to consumers.
Immobility of factors of production causes unemployment and therefore productive inefficiency.
Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and subsequent social exclusion that the government may wish to correct.
Markets and the functions of price
Market failure can also occur when one or more of the three functions of prices break down.
Signaling function of prices breaks down in the case of externalities since the full costs and benefits of market transactions are not taken into account (included in the price).
Incentive function – monopolies often charge high prices, which should create an incentive for other firms to enter the market but significant barriers to entry often exist.
Rationing effect – current high prices of petrol should lead to a considerable rationing effect and reduced consumption but this does not appear to be the case.
