What Market Failure Means
Definition
Market failure: a misallocation of resources by the free market, so that output differs from the socially optimal level.
Social optimum: the output where marginal social benefit = marginal social cost (MSB = MSC), which maximises society's welfare.
- Because the market ignores some costs or benefits, output settles above or below the social optimum.
- This misallocation provides the case for possible government intervention.
Key Idea
- Market failure is a misallocation of resources, not simply an outcome someone dislikes.
- It means over-provision or under-provision relative to the social optimum (MSB = MSC).
Complete and Partial
- Complete market failure occurs when no market exists to provide a good at all, a missing market.
- Partial market failure occurs when a market exists but produces the wrong quantity.
- Resources are misallocated in both cases, only to a different degree.
Example
- Coastal flood defence has essentially no market, since no firm can charge beach-front households individually → complete market failure.
- The UK petrol market shows partial market failure: it exists and sells billions of litres, but over-produces because drivers do not pay for the pollution and congestion they cause.
Missing the Optimum
- The social optimum is the output where marginal social benefit = marginal social cost (MSB = MSC).
- Goods with negative externalities are over-produced beyond that optimum, because private cost < social cost.
- Goods with positive externalities are under-produced below that optimum, because private benefit < social benefit.
Example
- Suppose the social optimum for a fuel is 80 million litres (where MSB = MSC), but the free market supplies 100 million litres because polluters ignore external costs.
- The extra 20 million litres are the over-provision that defines this market failure, since each unit adds more social cost than social benefit.
Main Sources
- Externalities and public goods are two central sources.
- Information failure, including asymmetric information, is another.
- Market imperfections such as monopoly power, factor immobility and inequality complete the list.
- Whether any of these justifies intervention depends on its scale and on the risk of government failure worsening the outcome.
Exam technique
- Define market failure as a misallocation of resources relative to the social optimum.
- Distinguish complete from partial failure to add precision to your answer.
Common Mistake
- Do not call any outcome you dislike a market failure.
- Reserve the term for a genuine misallocation of resources away from MSB = MSC.
Self review
- Define market failure.
- What is complete market failure?
- What is partial market failure?
- Where does the social optimum lie?
- Name three sources of market failure.
