Types of Market Failure (Edexcel A Level Economics A) : Revision Note

Understanding Market Failure

• In a free market, the price mechanism determines the most efficient allocation of scarce resources in response to the competing wants and needs in the marketplace

  • Scarce resources are the factors of production (land, labour, capital, and enterprise)

  • Free markets often work very well

• However, the free market sometimes leads to market failure, a situation where there is a less than optimal allocation of resources from the point of view of society

  • For example, when the free market causes a lack of equity (inequality) or environmental degradation

• Market failure leads to either an over-provision or under-provision of the goods and services and therefore an over-allocation or under-allocation of the resources (factors of production) used to make these goods and services

  • From society’s point of view, there is a lack of allocative efficiency or a misallocation of resources

Types of Market Failure

• Sources of market failure include the existence of externalities, an under-provision of public goods, and the existence of information gaps in markets

Externalities

• Externalities occur when there is an external impact (cost or benefit) on a third party not involved in the economic transaction

  • These impacts can be positive or negative. There are two positive externalities (in consumption and production) and two negative externalities (in consumption and production)

  • A positive externality of consumption occurs when the external impact on a third party is positive, such as when electric vehicles are consumed, CO2 emissions fall, resulting in fewer respiratory diseases

  • A positive externality of production occurs when the external impact on a third party is positive, such as when managed pine forests produce timber but also increase CO2 absorption, improving climate change.

  • A negative externality of consumption occurs when the external impact on a third party is negative, such as when the consumption of alcohol increases anti-social behaviour, increasing policing costs

  • A negative externality of production occurs when the external impact on a third party is negative, such as the production of electricity through non-renewable sources, increasing air pollution and greater healthcare costs

  • If these externalities were acknowledged, then the socially optimum price and quantity in the market would be different to the free market price and quantity

  • The price mechanism in a free market ignores these externalities

Public Goods

• Public goods are beneficial to society but would be under-provided by a free market as there is less opportunity for sellers to make economic profits from providing these goods/services

  • Good examples include national defence, parks, libraries and lighthouses

  • They are therefore provided by the government for the public benefit

Information Gaps

• Information gaps exist in all free markets and distort market outcomes, resulting in market failure

  • One of the underlying assumptions of a free market is that there is perfect information in the market

  • The reality is that in many markets, buyers and sellers have different levels of information. This is called asymmetric information and distorts market prices and quantities

  • For example, goods/services with dangerous side effects would be sold in lower quantities if buyers were aware of these effects. Similarly, goods/services with extra benefits would be sold in higher quantities if buyers were aware of them

  • Market failure, particularly information gaps, was the primary cause of the 2008 financial crisis since even financial industry experts were not fully aware of the complexity of the financial products being developed and marketed