Market failure
Meaning and essential terms
- Market failure - a situation in which the price mechanism allocates resources inefficiently, so some goods are overprovided, underprovided or not provided.
- Third party - a person or organisation affected by an economic decision but not directly involved as its buyer or seller.
- Private benefit - a benefit received directly by the consumer or producer making a decision.
- External benefit - a benefit received by a third party.
- Social benefit - the total benefit to society: private benefit plus external benefit.
Benefit relationship: Social benefit = private benefit + external benefit
- Private cost - a cost paid directly by the consumer or producer making a decision.
- External cost - a cost imposed on a third party.
- Social cost - the total cost to society: private cost plus external cost.
Cost relationship: Social cost = private cost + external cost
In economics, decision makers often compare private benefit and cost without considering external benefit or cost, aka externalities (because they do not have to pay for any 3rd party consequences). This is a common cause of market failure, where resources are not allocated as efficiently as possible.
Goods linked to market failure
- Non-excludable - people cannot feasibly be prevented from benefiting, even if they do not pay.
- Non-rival - one person's use does not reduce the amount available to others.
- Public good - a good that is non-excludable and non-rival, such as national defence or street lighting.
- Free-rider problem - the issue where public goods can be consumed without payment. Hence, why some public goods cannot be privately supplied; there is no reward of profit for the producer.
- Merit good - a good that creates private or external benefits and is underconsumed if left to the market, often because consumers underestimate its benefits. Examples include education and vaccinations.
- Demerit good - a good that creates private or external costs and is overconsumed if left to the market, often because consumers underestimate its harm. Examples include tobacco and excessive alcohol.
- Monopoly - a market with one seller. A firm with strong monopoly power can influence price and output because consumers have few or no close alternatives.
Causes and consequences of market failure
There are many causes of market failure, not just limited to externalities.
| Cause | Why resources are misallocated | Likely consequence |
|---|---|---|
| Public goods | The free-rider problem makes charging users difficult, so private provision is not profitable. | The good may not be provided, despite substantial social benefit. |
| Merit goods / external benefits | Consumers consider too little of the full social benefit or lack accurate information. | Underconsumption and underproduction, such as too little education or vaccination. |
| Demerit goods / external costs | Consumers and producers do not bear or recognise all social costs. | Overconsumption and overproduction, such as excess smoking or pollution. |
| Monopoly power | Weak competition reduces pressure to keep prices low, output high and quality strong. | Restricted supply, higher prices, less choice and possibly less innovation. |
Examples of external effects
| Decision | Private effect | External effect | Overall result |
|---|---|---|---|
| A firm pollutes a river | The firm may enjoy lower disposal costs. | Residents and other firms face health or clean-up costs. | Social cost exceeds private cost; output may be too high. |
| A commuter drives at rush hour | The driver gains convenient travel. | Other road users suffer extra congestion and pollution. | The journey imposes an external cost. |
| A student receives education | The student may gain knowledge and higher income. | Society may gain higher productivity and lower crime. | Social benefit exceeds private benefit; consumption may be too low. |
| A person is vaccinated | The person is less likely to become ill. | Others face a lower risk of infection. | The decision creates an external benefit. |
How to analyse a market-failure example
- Identify the decision. State what is produced or consumed.
- Identify who is affected. Separate the buyer or seller from third parties.
- Compare private and social effects. Explain any ignored external cost or benefit.
- State the misallocation. Conclude whether the product is overprovided, underprovided or not provided.