An Introduction to Market Failure (AQA A Level Economics)

Revision Note

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Written by: Steve Vorster

Reviewed by: Jenna Quinn

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, enterprise)
- Free markets often work very well

However, the free market sometimes leads to market failure, where there is a less than optimum allocation of resources from the point of view of society
If resources were allocated in a different way, more output could be produced
For example, when the free market causes a lack of equity (inequality) or environmental degradation
- There is either over-provision or under-provision of the goods/services and therefore an over-allocation or under-allocation of the resources (factors of production) used to make these goods/services
- From society’s point of view, there is a lack of allocative efficiency
- Economic or social welfare is not maximised when there is a market failure

Complete Versus Partial Market Failure

A complete market failure occurs when there is a missing market
- The market does not supply products at all despite society having demand for it
- This is the case for public goods, for example the provision of national defence
A partial market failure occurs where the market exists, but does not provide resources in the optimum quantities
- There is an over production/consumption or under production/consumption of a good or service

Examiner Tips and Tricks

Most market failures in A Level Economics are partial market failures which involve a deadweight loss to society, but you need to be able to clearly distinguish between complete and partial market failures and give examples of each.

Worked Example

Which one of the following is most likely to result in complete market failure?

A. The existence of merit goods in markets

B. The government sets minimum prices for excludable and rival goods

C. Positive externalities in production and consumption

D. Non-excludability and no enforceable property rights

Answer:

D. Non-excludability and no enforceable property rights

Private firms lack the incentive to provide goods or services. There is no way to charge consumers if everyone has access to the resource (non-excludable and with no property rights). This results in a missing market

Causes of Market Failure

From society’s point of view, market failure occurs when there is lack of efficiency in the allocation of resources

Causes of Market Failure

Cause	Explanation
Public goods	Public goods are beneficial to society but would be under-provided by a free market, e.g. flood defences
Externalities	Occur when there is an external impact on a third party not involved in the economic transaction between the buyer and seller, e.g. passive smoking, which is considered a negative externality These impacts can be positive or negative and are often referred to as spillover effects These impacts can be on the production side of the market (producer supply) or on the consumption side of the market (consumer demand)
Tradegy of the commons	The tragedy of the commons occurs when common pool resources are used by either the producer or consumer in a way that is not sustainable When left to the free market, there is no private ownership over these resources as it is costly and inefficient to find ways to exclude other producers
Merit & demerit goods	Merit goods are goods or services that are beneficial to consumer and society but the free market does not provide enough of them e.g. education or healthcare Demerit goods are goods which have harmful impacts on consumers or society, e.g. cigarettes
Market imperfections	There are three types of market imperfections: imperfect information, monopoly/monopoly power and factor immoblity Imperfect information is when buyers and sellers have different levels of information in a market and this can distort market outcomes, resulting in market failure Monopoly power causes market failures when a monopolist charges higher prices, which may lead to under consumption and reduced output, resulting in a partial market failure Factor immobility is when factors of production are unlikely to be perfectly mobile If they are immobile and cannot be easily reallocated to match a change in demand, markets will not clear, resulting in the misallocation of resources and partial market failure
Unequal distribution of income and wealth	The unequal allocation of wealth or income can result in a misallocation of resources and market failure When wealth or income is not distributed in society, some consumers may not be able to afford to purchase goods and services This could lead to poverty or increased negative externalities such as social unrest

Last updated: 14 October 2024

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