What is market failure?
In a free market, prices tell firms what to make and how much. Often this works well. But sometimes the market gives the wrong amount of a good for society as a whole.
Market failure means the free market does not use resources in the best (most efficient) way. Society could be better off if the amount changed.
- Private cost/benefit: the cost or benefit to the buyer or seller.
- External cost/benefit: the cost or benefit to other people (third parties).
- Social cost = private cost + external cost. Social benefit = private benefit + external benefit.
The socially efficient amount is where marginal social benefit = marginal social cost. The market stops where only the private ones are equal. The gap between the two amounts is a welfare loss (deadweight loss).
Externalities: negative and positive
Negative externality: a harm to others. Examples: factory smoke, loud music, traffic jams, smoking near others. The good is over-produced because the seller ignores the harm.
Positive externality: a benefit to others. Examples: vaccination (you protect others too), education, a neat garden. The good is under-produced because buyers ignore the benefit to others.
Worked idea
Demand: P = 100 − Q. Private cost: P = 20 + Q. External cost: 20 per unit. Market: 100 − Q = 20 + Q gives Q = 40. Social: 100 − Q = 40 + Q gives Q = 30. So 10 units too many.
Public goods, merit goods and demerit goods
A private good is rival (if I eat the apple, you cannot) and excludable (the seller can stop people who do not pay).
A pure public good is non-rival and non-excludable: street lights, flood defences, national defence, a lighthouse. Because people can enjoy it without paying, many wait for others to pay. This is the free-rider problem. A firm cannot earn money, so the market provides none: a missing market.
Merit goods (education, health check-ups) are better for people than they think, so they are under-consumed. Demerit goods (tobacco, alcohol) are worse than people think, so they are over-consumed.
Information gaps, market power and inequality
Imperfect information: buyers or sellers do not know everything. Asymmetric information means one side knows more. A used-car seller knows the car's faults; the buyer does not. Good cars may then leave the market.
Market power: a monopoly can charge a higher price and make less than society wants. Other imperfections: factors of production that cannot move easily (immobility of labour), and firms working together (cartels).
Inequality: a market can be efficient but still leave some people very poor. Many people see a very unequal spread of income and wealth as a kind of market failure.
How governments respond (and government failure)
- Indirect tax on harmful goods (a pollution tax). It makes the firm pay the external cost: "the polluter pays".
- Subsidy for goods with external benefits (vaccines, solar panels).
- Rules and bans: limits on smoke, a minimum age for alcohol.
- Tradable pollution permits: a fixed total amount of pollution; firms can buy and sell permits.
- Direct provision: the state pays for public goods from taxes (street lights, roads).
- Information: labels, warnings, ratings.
- Competition law and price rules for monopolies.
Government failure: the fix can make things worse, because of poor information, high costs, unexpected side effects or political pressure.
Key formulas and definitions
- Social cost = private cost + external cost
- Social benefit = private benefit + external benefit
- Efficient output: MSB = MSC
- Welfare loss = ½ × (extra units) × (gap between MSC and MSB)
- Ideal pollution tax per unit = external cost per unit
Worked examples
1. Demand P = 100 − Q, private cost P = 20 + Q, external cost 20 per unit. Find market output and the socially best output.
Market: 100 − Q = 20 + Q, so 2Q = 80, Q = 40. Social cost is 40 + Q. Social: 100 − Q = 40 + Q, so Q = 30. The market over-produces by 10 units.
2. In the same market, find the welfare loss.
At Q = 40, MSC = 80 and MSB = 60. The gap is 20. Welfare loss = ½ × (40 − 30) × 20 = 100.
3. What tax per unit fixes the market? Show the new output.
Tax = external cost = 20. The firm's cost becomes 40 + Q. 100 − Q = 40 + Q gives Q = 30, the social optimum.
4. Classify: (a) a fireworks show in the sky, (b) a cinema ticket, (c) a vaccine.
(a) Public good: non-rival and hard to exclude. (b) Private good: rival seat, excludable. (c) Merit good with a positive externality: it protects others.
Common mistakes
- Thinking market failure means the market has stopped completely. It means the amount is wrong for society.
- Mixing up public goods with goods the government provides. Schools are provided by the state but are not pure public goods.
- Saying a negative externality leads to under-production. It leads to over-production.
- Forgetting that government action can also fail.