Market Failure

Definition of Market Failure This occurs when there is an inefficient allocation of resources in a free market. Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less output), negative externalities (over-consumed) and public goods (usually not provided in a free market)

Types of market failure:

  1. Positive externalities – Goods/services which give benefit to a third party, e.g. less congestion from cycling
  2. Negative externalities – Goods/services which impose cost on a third party, e.g. cancer from passive smoking
  3. Merit goods – People underestimate the benefit of good, e.g. education
  4. Demerit goods – People underestimate the 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 the 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 – due to volatile prices and externalities.
  10. Information failure – where there is a lack of information to make an informed choice.
  11. Principal-agent problem – Two agents with different objectives and information asymmetries

 

Key Terms in Market Failure

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

Market failure and behavioural economics

Behavioural economics examines how individuals often act in a non-rational manner – contrary to the expectation of conventional economic models. These types of ‘irrational behaviour’ can lead to a type of market failure where people make poor choices. For example.

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