Market Failure

Markets are powerful — but they don't always get it right. Market failure is when the free market, left alone, leads to a misallocation of resources, so society's welfare is not maximised.

Learning objectives — by the end of 1.3 you can…

- explain market failure and distinguish complete from partial failure; - draw all four externality diagrams and identify the welfare loss; - explain merit and demerit goods, and the value judgements involved; - explain public goods, non-rivalry, non-excludability and the free-rider problem; - explain how information gaps (imperfect & asymmetric) cause failure.

1.3.1 Types of market failure

Market failure occurs when the price mechanism allocates resources inefficiently — too much of some goods is produced, too little of others.

Complete market failure — the market fails to provide a good at all (a "missing market", e.g. pure public goods).
Partial market failure — the good is provided, but in the wrong quantity or at the wrong price.

1.3.2 Externalities

An externality is a cost or benefit imposed on a third party — someone not involved in the transaction. Because no one pays or is paid for it, the market ignores it.

Key Terms — the building blocks

Private cost / benefit — The cost or benefit to the individual making the decision (the firm or consumer).

External cost / benefit — The cost or benefit to third parties.

Social cost / benefit — Private + external. The true cost/benefit to society as a whole.

On diagrams these become marginal curves: MPC, MPB (private) and MSC, MSB (social). The social optimum is where MSB = MSC; the free market settles where MPB = MPC. The gap is measured by a welfare loss triangle.

#### Negative externality of production

e.g. a factory polluting a river. The firm's private cost ignores the pollution, so MSC lies above MPC. The market over-produces at Q₁.

#### Negative externality of consumption

e.g. smoking or junk food (demerit goods). The harm to others/future-self means MSB lies below MPB. The market over-consumes at Q₁.

#### Positive externality of consumption

e.g. education or vaccination (merit goods). Others benefit too, so MSB lies above MPB. The market under-consumes at Q₁.

#### Positive externality of production

e.g. a firm training workers, or R&D that spills knowledge to rivals. Society's cost is lower than the firm's, so MSC lies below MPC, and the market under-produces at Q₁ (the optimum Q* is higher).

Merit & demerit goods

Merit good — A good that is under-consumed and brings positive externalities & long-term private benefits people underestimate (education, healthcare, exercise). Society wants more consumed.

Demerit good — A good that is over-consumed and brings negative externalities & long-term harm people underestimate (tobacco, alcohol, gambling). Society wants less consumed.

Both involve a value judgement by the government about what is "good" for people — so labelling something a merit/demerit good is partly normative.

Exam Tip — drawing externality diagrams

Method that never fails: (1) draw the private curves (MPB, MPC) and find the market outcome Q₁; (2) add the social curve that's affected, shifted in the right direction; (3) find Q* where MSB = MSC; (4) shade the welfare-loss triangle that "points to" the social optimum. Label every curve and both quantities.

Evaluation

Externalities are real but hard to value — putting a precise £ figure on pollution or the benefit of education is difficult, so the exact size of the welfare loss is uncertain. The significance also depends on scale: a small local externality may not justify costly intervention, whereas climate change clearly does.

1.3.3 Public goods

Some goods the free market won't provide at all. A pure public good has two features:

Non-excludability creates the free-rider problem: since people can enjoy the good without paying, everyone waits for someone else to pay. No one does, so no profit-seeking firm will supply it — a missing market (complete market failure). This is why government provides goods like national defence, street lighting, flood defences and the police, funded through taxation.

Quasi-public goods

Most "public" goods are really quasi-public — only partly non-rival or non-excludable. A road is non-rival until it gets congested, and can be made excludable with tolls. A beach is open to all but can become crowded.

1.3.4 Information gaps

Rational choice assumes people have perfect information. In reality they don't, and that leads to a misallocation of resources.

Key Terms

Imperfect information — Buyers or sellers lack full knowledge of a product's costs, benefits or quality.

Asymmetric information — One side of a transaction knows more than the other, and can exploit it.

Consequences and examples:

Under-consumption of merit goods / over-consumption of demerit goods — people underestimate the long-term benefit of education or harm of smoking.
Adverse selection — a used-car seller knows the car's faults; the buyer doesn't ("the market for lemons"). Bad products drive out good ones.
Healthcare & pensions — patients can't judge treatments as well as doctors; many people fail to grasp the need to save for retirement.
Moral hazard — once insured, people may take more risks because they don't bear the full cost.

1.3 Recap — nail these

- Market failure = misallocation of resources; it can be complete (missing market) or partial. - Externalities: market settles at MPB=MPC, optimum at MSB=MSC; shade the welfare-loss triangle. Know all four diagrams. - Public goods are non-rival & non-excludable → free-rider problem → under-provision. - Information gaps (imperfect & asymmetric) cause poor decisions — adverse selection, moral hazard.