Market failure

What market failure means

A market is allocatively efficient when it produces where marginal social benefit (MSB) equals marginal social cost (MSC). Market failure happens when the free market produces a different quantity, creating a welfare loss.

Types of market failure

Negative externalities

• Of production: a factory's pollution means MSC is above marginal private cost (MPC). The market overproduces.
• Of consumption: smoking harms others, so MSB is below marginal private benefit (MPB). The market overconsumes.

Positive externalities

• Of production: firm training benefits other employers, so MSC is below MPC. The market underproduces.
• Of consumption: vaccinations protect others, so MSB is above MPB. The market underconsumes.

Public goods are non-rivalrous and non-excludable, such as street lighting. Because of the free-rider problem, the market may not provide them at all.

Common pool resources, such as fish stocks, are rivalrous but non-excludable, so they tend to be overused. This links to sustainability.

Asymmetric information happens when one side of a market knows more than the other, as in second-hand cars or insurance.

Market power lets firms restrict output and raise prices above the efficient level.

Drawing the diagrams

For each externality, draw the private curve and the social curve, mark the market quantity and the socially optimal quantity, and shade the welfare loss triangle between them. Label every curve and axis; examiners give marks for accurate diagrams.

Government responses

• Indirect taxes (such as a carbon tax) to internalise negative externalities.
• Subsidies for goods with positive externalities, such as education.
• Regulation and legislation, such as emission limits or smoking bans.
• Tradable permits for pollution.
• Direct provision of public goods.
• Education and nudges to change behaviour.

Evaluating policies

Strong Paper 1 part (b) answers weigh up each policy: how large the effect is likely to be (think about PED), the cost to the government, the risk of government failure, the effect on equity, and short-run compared with long-run results. Use a real example and reach a justified conclusion.

Common mistakes

• Shading the wrong welfare loss triangle.
• Mixing up which curve shifts for production and consumption externalities.
• Recommending a policy without discussing its drawbacks.