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.