Market Failure: Market Imperfections (AQA A Level Economics)

Imperfect Information & Market Failure

• Information gaps exist in nearly all free markets and distort market outcomes, resulting in partial market failure
   

• One of the underlying assumptions of a free market is that there is perfect information in the market

  • Buyers and sellers have the same level of information about the good/service. This is called symmetric information

•  Asymmetric (imperfect) information distorts socially optimal prices and quantities in markets, resulting in over- or under-provision of goods/services

  • Imperfect information refers to a situation when buyers and/or sellers have inaccurate information or do not have all the information necessary to make an informed decision

  • This distorts socially optimal prices and quantities in markets, resulting in over- or under-provision of goods and services and market failure

  • Sellers may be aware of product defects which are not communicated to buyers

    • Goods and services with dangerous side effects would be sold in lower quantities if buyers were aware of these effects (consider the VW emissions scandal). Fewer factors of production should be allocated towards producing these

    • Similarly, goods and services with extra benefits would be sold in higher quantities if buyers were aware of them. More factors of production should be allocated towards producing these

Monopoly Power & Market Failure

• Market power refers to the ability of a firm to influence and control the conditions in a specific market, allowing them to have a significant impact on price, output, and other market variables
   

• A pure monopoly exists when there is only one producer in the market. A firm with monopoly power controls over 25% of the market share (in the UK) and, as such can act as a pure monopoly
  

• Monopolies have market power and can set higher prices for consumers to earn abnormal profits

  • Monopoly markets are characterised by high barriers to entry making it difficult for other firms to join the market

  • There is no incentive for a monopoly power to be economically efficient which leads to higher prices and reduces consumer welfare

  • Markets are not allocatively efficient and a misallocation of scarce resources results in market failure

  • In a monopoly market, consumers pay a higher price and firms produce lower output than under firms in perfect compeition

  • Scarce resources are not allocated efficiently, resulting in a market failure

Factor Immobility & Market Failure

• The mobility of the factors of production refers to how easily firms can switch between different factors of production
  

• The more mobile the factors, the more flexibility there will be in production

  • E.g. If a firm can produce both cars and trucks on its production line, and switching from one to the other only requires a few simple changes to some robotic arm extensions, then its capital is very mobile

  • This means that the firm can be very responsive to changes in demand for cars and trucks and is likely to make more profit

• Factor immobility occurs because of difficulties in reallocating factors of production to alternative uses

  • If factors are immobile, then markets will find it difficult to clear when there is a change in supply and demand

  • E.g If demand increases but supply is fixed due to immobile factors of production, it will take time for a new market equilibrium to be reached

  • This can result in the misallocation of resources, leading to market failure

• Land, capital and labour can all be immobile

  • Enterprise encompasses a worker who combines the other factors of production to earn profit

  • Enterprise is generally very mobile, as the skills involved can be applied in every industry. Someone who has borne risks and organised factors of production in the car industry should be able replicate this in the retail industry too

  • All natural resources that come from the earth and are used in the production of goods or services

Factor Mobility of Land, Capital & Labour