Edexcel A-Level Economics · Revision notes

1.3.1 Types 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 topic defines market failure and introduces its three main types, each of which has a statement 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 three types 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.

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 at the end of this theme.

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

This topic has not appeared as a standalone question in the Edexcel papers indexed on this site.

It is an overview, so the detail is examined through the three statements that follow it, each of which covers one type of market failure in depth.

Where this goes next

Each type has its own topic: 1.3.2 Externalities, 1.3.3 Public goods and 1.3.4 Information gaps. Government responses to market failure are covered in 1.4.1 Government intervention in markets, and the risk that intervention makes things worse in 1.4.2 Government failure. The idea that markets allocate resources through prices is in 1.2.7 Price mechanism.