1.8.2a Meaning and types of market failure

Market Failure Is a Misallocation of Resources by the Free Market

1. Market failure is when the free market misallocates resources.
2. Too much or too little of a good is produced and consumed.
3. The outcome differs from the socially optimal level.
4. It can be complete or partial.

Market Failure Can Be Complete or Partial

1. Complete market failure means a market is missing entirely.
2. No market exists to provide the good.
3. Partial market failure means a market exists but allocates badly.
4. Resources are still misallocated in both cases.

Several Distinct Sources Cause Market Failure

1. Externalities and public goods are key sources.
2. Merit and demerit goods and information failure are others.
3. Monopoly power and factor immobility also cause failure.
4. Inequality in the distribution of income and wealth is sometimes included as well.

Reading the Market Failure Diagram

1. The vertical axis shows price, and the horizontal axis shows the quantity of the good.
2. Marginal social cost (MSC) is the upward-sloping curve, showing the rising cost to society of producing each extra unit.
3. Marginal social benefit (MSB) is the downward-sloping curve, showing the falling benefit to society from each extra unit consumed.
4. The social optimum is where MSC = MSB, at quantity $Q^{\ast }$ and price $P^{\ast }$, because every unit whose social benefit is at least its social cost is produced and no more.
5. Here the market produces only $Q_1$, which lies to the left of $Q^{\ast }$, so the good is under-produced relative to the social optimum.
6. The shaded triangle between the MSB and MSC curves over the range $Q_1$ to $Q^{\ast }$ is the deadweight welfare loss (DWL), the net benefit society loses because output stops short of the optimum, since on those units MSB is greater than MSC.

UK Application: Under-Provision of Vaccination

1. Vaccination creates a positive externality, since one person being immunised also lowers the risk of infection for everyone around them.
2. Because individuals ignore this wider social benefit, the marginal social benefit lies above their private benefit, so a free market would under-provide vaccination at $Q_1$.
3. This is partial market failure, since a market for vaccines exists but produces less than the socially optimal quantity $Q^{\ast }$, which is why the NHS provides many vaccines free.

Market Failure Means Genuine Inefficiency, Not Any Disliked Outcome

1. Market failure means genuine inefficiency.
2. It is not just any outcome a person dislikes.
3. It provides the case for possible government action.
4. So the term must be used precisely.

Define Market Failure, Then Distinguish Complete From Partial

1.8.2b Causes of market failure

Inequality: When the Market Distributes by Ownership

1. The unregulated market shares income by the ownership of factors.
2. This can give a very unequal, arguably inequitable outcome.
3. It is often treated as a market failure, since the ability to consume depends on income, not need.
4. This section focuses on inequality in the distribution of income and wealth; the other causes of market failure, namely public goods, externalities, merit and demerit goods, and monopoly and other market imperfections, are covered in sections 1.8.3 to 1.8.6.

Inequality Sends Resources Toward Ability to Pay, Not Need

1. Scarce goods flow to those who can pay, not to those who need them most.
2. That can misallocate resources away from basic needs.
3. It builds the case for redistribution through tax and benefits.

Worked Example: Ability to Pay Versus Need

1. Suppose a course of private medical treatment costs £10,000\pounds 10{,}000£10,000.
2. For a household earning £15,000\pounds 15{,}000£15,000 a year, this represents about $67\%$ of their annual income, an amount most could not afford without government support.
3. For a household earning £150,000\pounds 150{,}000£150,000 a year, the same treatment is only about $7\%$ of income, easily affordable.

UK Application: Evidence of Resources Not Reaching Need

1. The Trussell Trust, a UK food bank charity, distributes several million emergency food parcels a year, evidence that some households cannot afford basic necessities even while food is plentiful and available in the market.
2. The UK's income Gini coefficient of around $0.35$ shows a persistent gap between the top and bottom of the income distribution, reinforcing the case that the market alone does not allocate all goods according to need.

Whether Inequality Is a Failure Depends on a View of Fairness

1. Whether inequality is a failure rests partly on a view of fairness.
2. Some inequality can reward effort and encourage enterprise.
3. On balance, extreme inequality is widely seen as a failure worth addressing.

Separate Equality From Equity and Flag Value Judgements