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:
- Positive externalities – Goods/services which give benefit to a third party, e.g. less congestion from cycling
- Negative externalities – Goods/services which impose cost on a third party, e.g. cancer from passive smoking
- Merit goods – People underestimate the benefit of good, e.g. education
- Demerit goods – People underestimate the costs of good, e.g. smoking
- Public Goods – Goods which are non-rival and non-excludable – e.g. police, national defence.
- Monopoly Power – when a firm controls the market and can set higher prices.
- Inequality – unfair distribution of resources in free market
- Factor Immobility – E.g. geographical / occupational immobility
- Agriculture – Agriculture is often subject to market failure – due to volatile prices and externalities.
- Information failure – where there is a lack of information to make an informed choice.
- 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
- Tax on Negative Externalities – e.g. Petrol tax
- Carbon Tax e.g. tax on CO2 emissions
- Subsidy on positive externalities – why government may subsidies public transport
- Laws and Regulations – Simple and effective ways to regulate demerit goods, like a ban on smoking advertising.
- Buffer stocks – aim to stabilise prices
- Government failure – why government intervention may not always improve the situation
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.
- Irrational exuberance – people getting carried away by good news leading to boom and bust.