Market Failure Terminology

Defining market failure

Defining market failure

• Market failure occurs when the free market fails to allocate resources efficiently, resulting in a loss of social welfare

  • It can lead to too much or too little of a good or service being produced or consumed from society’s point of view

  • For example, pollution caused by factories is not reflected in market prices — this is a market failure

• Free markets often work very well 

• However, these free market can fail when there is a less than optimum allocation of resources from the point of view of society

  • Sometimes there is an over-provision of goods or services which are harmful (demerit goods) and therefore an over-allocation of the resources (factors of production) used to make these goods/services, e.g., cigarettes 

  • Sometimes there is an under-provision of the goods or services which are beneficial (public goods and merit goods) and therefore an under-allocation of the resources (factors of production) used to make these goods and services, e.g., schools.

  • Sometimes the market causes a lack of equity (inequality) – the rich get richer and the poor get relatively poorer

  • Sometimes, environmental damage occurs during the production or consumption of a good or service  

• In each of these cases, from society’s point of view there is a lack of efficiency in the allocation of resources

External costs and benefits

External costs and benefits

• Externalities occur when there is an external impact on a third party not involved in the economic transaction between the buyer and seller

  • These impacts can be positive (benefits) or negative (costs) 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)

Costs

Social cost = private cost + external cost 

• Private costs

  • These are what the producer, consumer or government actually pay to produce or consume a good or service

    • For example, a consumer pays $9 for a McDonald's meal

• External costs

  • These are the damages not factored into the market transaction

    • For example, the consumer throws their McDonald's packaging onto the street and the Government has to hire cleaners to collect the litter

• Social costs

  • These includes both the private cost and the external cost to society

    • It is a better reflection of the true cost of an economic transaction

Benefits

Social benefit = private benefit + external benefit

• Private benefits

  • These are what the producer, consumer or government actually gain from producing or consuming a good or service

    • For example, a bee farmer gains the private benefit of the income from selling their honey

• External benefits

  • An external benefit (positive externality) is the benefit not factored into the market transaction

    • For example, the bees from the bee farm pollinate the nearby apple orchards 

• Social benefits

  • These include both the private benefit and the external benefit to society

    • It is a better reflection of the true benefit of an economic transaction