Types of Market Failure
Market failure: when the free market, left to itself, allocates resources inefficiently, so society's welfare is not maximised.
Complete market failure: when a market is missing altogether and the good is not provided at all (a missing market).
Partial market failure: when a market does exist but delivers the wrong quantity, producing either too much or too little.
Social optimum: the level of output at which society's welfare is maximised, where all social costs and benefits are taken into account.
- In a free market, self-interested buyers and sellers weigh only their own private costs and benefits.
- They ignore any costs or benefits that spill over to third parties, so the market price and quantity need not match the socially optimal level.
- When output diverges from the social optimum, resources are misallocated and a welfare loss follows.
- Over-production or under-provision both mean society could be made better off by reallocating resources, which is the essence of inefficiency.
- Edexcel identifies three main sources of market failure: externalities, the under-provision of public goods, and information gaps.
- Each one breaks the assumption that private decisions reflect the full value of a good to society.
Externalities
Externality: a cost or benefit from a transaction that falls on a third party who is not part of that transaction.
Negative externality: a spillover cost imposed on third parties, such as pollution from burning fossil fuels.
Positive externality: a spillover benefit enjoyed by third parties, such as the herd immunity created when one person is vaccinated.
- With a negative externality, the market over-produces because polluters weigh only their private cost and ignore the extra cost falling on society.
- With a positive externality, the market under-produces because buyers weigh only their private benefit and ignore the extra benefit to others.
- A factory polluting a river is a negative production externality: the market over-supplies because the firm weighs only its private cost and ignores the external cost. The same logic drives high-carbon energy, which the UK ETS taxes by pricing each tonne of carbon.
- The MMR vaccine is a positive consumption externality: herd immunity benefits third parties, so the market under-supplies because buyers ignore that external benefit. Vaccination is a merit good, under-consumed relative to the social optimum.
- Sugary drinks are a demerit good, over-consumed because buyers underestimate the long-term harm; the UK Soft Drinks Industry Levy, collected by HMRC, is designed to cut consumption.
Public Goods
Public good: a good that is both non-rival and non-excludable, which the free market under-provides or fails to provide at all.
Non-rivalry: one person's consumption does not reduce the amount available to others.
Non-excludability: once the good is provided, no one can be stopped from consuming it, even if they have not paid.
Free-rider problem: because non-payers cannot be excluded, people consume without paying, so firms earn no revenue and choose not to supply.
- Because a public good is non-excludable, a firm cannot charge users, so it cannot earn the revenue needed to cover its costs.
- The free-rider problem therefore leaves the good missing or heavily under-provided, an example of complete market failure.
- National defence, street lighting, flood defences and a lighthouse are public goods (non-rival and non-excludable): one person's benefit does not reduce another's, and non-payers cannot be excluded, so no firm can charge and government must provide them.
- Contrast a private good such as a sandwich or a bus seat (rival and excludable), where the free market works, and a quasi-public good such as a road or a beach, which is non-rival until it becomes congested.
Information Gaps
Information gap: a situation where buyers or sellers lack the full information needed to make the decision that maximises their welfare.
Asymmetric information: one party in a transaction has more or better information than the other.
Merit good: a good that is under-consumed because people undervalue its private benefits, such as education.
Demerit good: a good that is over-consumed because people underestimate its private harm, such as sugary drinks.
- With imperfect or asymmetric information, consumers misjudge the true costs and benefits, so they over-consume demerit goods and under-consume merit goods.
- For example, buyers often underestimate the long-term harm of sugary foods, so they over-consume them.
- In each case resources are misallocated, creating a welfare loss and the potential case for government intervention.
- Define market failure as an inefficient allocation of resources, not simply an outcome you dislike.
- Identify which of the three types applies: externalities, under-provided public goods or information gaps.
- End with the welfare loss, which sets up the case for policy.
- Do not label any outcome you dislike a market failure, as the term means genuine inefficiency.
- Do not confuse complete failure, a missing market, with partial failure, a market that allocates badly.
- Do not stop at naming the cause without stating the misallocation it produces.
- What is market failure?
- What is the difference between complete and partial market failure?
- How do externalities cause market failure?
- Why are public goods under-provided by the free market?
- What is an information gap?
