AQA A-Level Economics · Revision notes

4.1.8.2 The Meaning of Market Failure

Markets usually allocate resources well. Prices signal what consumers want, and firms respond by producing it. But sometimes the price mechanism produces the wrong quantity of a good, or fails to produce it at all. This page defines market failure, distinguishes complete from partial market failure, and introduces its main causes, each of which has a page of its own.

What market failure means

Market failure occurs when the free market leads to a misallocation of resources: the quantity produced and consumed is not the one that would maximise society's welfare.

The key benchmark is the social optimum. This is the level of output where the full benefit to society of the last unit equals the full cost to society of producing it. When a market produces more or less than that, resources are being wasted. Society would be better off if some were moved into, or out of, that market.

Watch out: A market can fail without anyone behaving badly. Consumers and firms may each be acting rationally in their own interests. The failure is that their private decisions do not take account of all the costs and benefits involved.

Complete and partial market failure

• Complete market failure is when no market exists at all, even though there is a need for the good. This is sometimes called a missing market. Public goods are the main example.
• Partial market failure is when a market exists but produces the wrong quantity or charges the wrong price. Over-consumption of goods that harm others, such as alcohol or fuel, is an example.

The causes of market failure

1. Externalities

An externality is a cost or benefit that falls on a third party, someone not directly involved in buying or selling the good. Because the buyer and seller ignore it, the market produces the wrong amount.

• With negative externalities, such as pollution from a factory, the good is over-produced.
• With positive externalities, such as the benefits to others when someone is vaccinated, the good is under-consumed.

2. Under-provision of public goods

A public good has two features: once it is provided, people cannot be stopped from using it, and one person's use does not reduce what is available to others. Street lighting and national defence are examples.

Because people can benefit without paying, many choose not to pay, and private firms cannot make a profit. The good is under-provided or not provided at all. This is the clearest case of complete market failure.

3. Information gaps

An information gap occurs when buyers or sellers do not have the information they need to make a rational decision. Often one side knows more than the other, as when a second-hand car seller knows more about the car than the buyer.

Poor information means consumers may buy too much of goods whose harms they underestimate, too little of goods whose benefits they underestimate, or the wrong goods altogether.

4. Merit and demerit goods

When consumers underestimate the harm a good does to them, they consume too much of it. Smoking, excessive alcohol and gambling are examples. Goods that are over-consumed because people underestimate their costs are often called demerit goods.

When consumers underestimate the long-term benefits of a good, they consume too little of it. Education, pensions, health checks and vaccinations are examples. Goods that are under-consumed for this reason are often called merit goods.

Deciding which goods count as merit or demerit goods involves a value judgement.

5. Monopoly and other market imperfections

Monopoly power. Without regulation, firms can grow large enough to exploit consumers. A monopoly restricts output and raises price above the competitive level, so too few resources are allocated to the good. Other imperfections, such as the immobility of labour and other factors of production, stop resources moving to where they are most valued.

6. Inequalities in the distribution of income and wealth

Inequality. Market outcomes can leave large differences in income and wealth. Rationing by ability to pay allocates goods to those with money, not to those with the greatest need. The mechanism is efficient on its own terms while being silent about fairness. Judging whether a particular distribution is unfair involves a value judgement.

Why market failure matters

Market failure is the main economic justification for government intervention. If the free market fails to reach the social optimum, there is a case for the government to step in, through taxes, subsidies, regulation, direct provision or information.

Evaluation: But intervention can make things worse as well as better. Whether government action actually improves welfare is the question of government failure, covered in 4.1.8.10 Government failure.

Key terms

Common mistakes

• Defining market failure as a market collapsing. It means resources are misallocated, not that the market stops working.
• Confusing market failure with high prices. A high price is not a failure if it reflects the true costs and benefits involved.
• Calling every government-provided good a public good. Health care and education are provided by the state but are not public goods in the economic sense.
• Listing the types without the misallocation. Each type needs a link to over- or under-production relative to the social optimum.

How this has been examined

In the AQA papers indexed on this site, this topic has appeared in one format:

• 15-mark "Explain" essay — asked once (2022)

Where this goes next

The price mechanism that market failure departs from is covered in 4.1.8.1 How markets and prices allocate resources. Each cause has its own page: 4.1.8.3 Public goods, private goods and quasi-public goods, 4.1.8.4 Positive and negative externalities in consumption and production, 4.1.8.5 Merit and demerit goods and 4.1.8.6 Market imperfections, with inequality developed in 4.1.7.1 The distribution of income and wealth. Government responses are covered in 4.1.8.9 Government intervention in markets.