Market Failure

Definition of Market Failure

This occurs when there is an inefficient allocation of resources in a free market.

Types of market failure:

  1. Positive externalities – benefit to a third party, e.g. less congestion from cycling
  2. Negative externalities – cost imposed on a third party, e.g. cancer from passive smoking
  3. Merit goods – People underestimate benefit of good, e.g. education
  4. Demerit goods – People underestimate 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 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


Key Terms in Market Failure

  • Externalities:           These occur when a third party is affected by the decisions and actions of others.
  • Social benefit: is 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