What is Market Failure?

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What is Market Failure?

To understand what market failure is, we first need to look at markets working correctly.

The assumption is that if markets are working freely with no imperfections, this will give the most efficient outcome, but what does the most efficient outcome actually mean?

Well, if an economy is working efficiently:

  1. Firms will be producing at the lowest cost per unit possible (productive efficiency)
  2. The economy's resources will be allocated between firms and industries in the most efficient way (allocative efficiency)

So the economy will be at a point on rather than within its production possibility frontier.

A production possibility frontier (PPF) shows all the possible combinations of two mutually exclusive groups of goods where all the economy's resources are being used and in the most efficient way possible. It is important that both of those conditions are fulfilled for an economy to be in a situation on rather than within its PPF.

What is Market Failure?

Suppose our two mutually exclusive groups of goods are 'military goods' and 'non-military goods'.

Point A within the PPF represents a situation where:

  1. Not all of the economy's resources are being used
  2. Or all resources are being used but not at maximum efficiency
  3. Or a bit of both.

Let us assume we are at point A and in the second of the three situations above, with all resources being used (land, labour and capital), but that our military industries are not presently performing at full efficiency. If this industry were to become fully efficient, it would be possible to produce more military goods (hopefully as many as M1M2) without sacrificing any non-military goods. The economy would then move from point A to point B on the PPF, meaning that the economy would be both productively and allocatively efficient.

Once at point B the economy cannot make more of one type of good without sacrificing the production of another type of good. If, for example, the economy moved from point B to point C, the economy would make N1N2 more non-military goods, but at the expense of M2M3 military goods. This sacrifice is known as the opportunity cost.

Once you understand what market failure is, we need to look at the various reasons why markets do fail. Below are listed the key reasons why markets fail:

Externality This failure is due to a 'by-product' of a certain production process, or of consuming something, that affects a third party. This effect can be positive or negative.
The wrong market structure This failure is due to the market structure not following the only truly efficient market structure (i.e. perfect competition)
Public, merit and demerit goods This failure occurs as the goods being produced are of a nature that the market would under provide, over provide or even fail to provide, if the government did not intervene.
Other ways in which markets fail There are numerous other reasons why markets fail and these are listed further down in this topic.