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Market Failure. Market Failure. Definition: Where the market mechanism fails to allocate resources efficiently Social efficiency Allocative Efficiency Technical Efficiency Productive Efficiency. Market Failure. Social Efficiency = where external costs and benefits are accounted for

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Market failure1
Market Failure

  • Definition:

  • Where the market mechanism fails to allocate resources efficiently

    • Social efficiency

    • Allocative Efficiency

    • Technical Efficiency

    • Productive Efficiency

Market failure2
Market Failure

  • Social Efficiency = where external costs and benefits are accounted for

  • Allocative Efficiency = where society produces goods and services at minimum cost that are wanted by consumers

  • Technical Efficiency = production of goods and services using the minimum amount of resources

  • Productive Efficiency = production of goods and services at lowest factor cost

Market failure3
Market Failure

  • Allocative efficiency:

    • Also referred to as

  • Pareto Efficient Allocation – resources cannot be readjusted to make one consumer better off without making another worse off – zero opportunity cost!

    • After Vilfredo Pareto (1848 – 1923)

Market failure4
Market Failure

  • Market Failure occurs where:

    • Knowledge is not perfect - ignorance

    • Goods are differentiated

    • Resource immobility

    • Market power

    • Services/goods would or could not be provided in sufficient quantity by the market

    • Existence of external costs and benefits

    • Inequality exists

Market failure5
Market Failure

  • Imperfect Knowledge:

    • Consumers do not have adequate technical knowledge

    • Advertising can mislead or mis-inform

    • Producers unaware of all opportunities

    • Producers cannot accurately measure productivity

    • Decisions often based on past experience rather than future knowledge

Market failure6
Market Failure

  • Goods/Services are differentiated

    • Branding

    • Designer labels - they cost three times as much but are they three times the quality?

    • Technology – lack of understanding of the impact

    • Labelling and product information

Which one is the ‘quality’ item and why?

Market failure7
Market Failure

  • Resource Immobility

    • Factors are not fully mobile

    • Labour immobility – geographical and occupational

    • Capital immobility – what else can we use the Channel Tunnel for?

    • Land – cannot be moved to where it might be needed – e.g. London and South East!

Market failure8
Market Failure

  • Market Power:

    • Existence of monopolies and oligopolies

    • Collusion

    • Price fixing

    • Abnormal profits

    • Rigging of markets

    • Barriers to entry

Market failure9
Market Failure

  • Inadequate Provision:

  • Merit Goods and Public Goods

    • Merit Goods – Could be provided by the market but consumers may not be able to afford or feel the need to purchase – market would not provide them in the quantities society needs

    • Sports facilities?

Market failure10
Market Failure

  • Merit Goods

  • Education – nurseries, schools, colleges, universities – could all be provided by the market but would everyone be able to afford them?

Schools: Would you pay if the state

did not provide them?

Market failure11
Market Failure

  • Public Goods

    • Markets would not provide such goods and services at all!

  • Non- excludability – Person paying for the benefit cannot prevent anyone else from also benefiting - the ‘free rider’ problem

  • Non- rivalry –

    Large external benefits relative to cost – socially desirable but not profitable to supply!

A non- excludable good?

Would you pay for this?

Market failure12
Market Failure

  • De-Merit Goods

  • Goods which society over-produces

  • Goods and services provided by the market which are not in our best interests!

    • Tobacco and alcohol

    • Drugs

    • Gambling

Market failure13
Market Failure

  • External Costs and Benefits

  • External or social costs

    • The cost of an economic decision to a third party

  • External benefits

    • The benefits to a third party as a result of a decision by another party

Market failure14
Market Failure

  • External Costs

  • Decision makers do not take into account the cost imposed on society and others as a result of their decision

    • e.g. Pollution, traffic congestion, environmental degradation, depletion of the ozone layer, misuse of alcohol, tobacco, anti-social behaviour, drug abuse, poor housing

External costs
External Costs





Value of the negative

externality(Welfare Loss)

Social Cost



Socially efficient output is where





Quantity Bought and Sold

Market failure15
Market Failure

  • External benefits –

    • by products of production and decision making that raise the welfare of a third party

    • e.g. Education and training, public transport, health education and preventative medicine, refuse collection, investment in housing maintenance, law and order.

External benefits
External Benefits



Value of the positive

externality(Welfare Loss)


Social Benefits


Socially efficient output

is where







Quantity Bought and Sold

Market failure16
Market Failure

  • Inequality:

    • Poverty – Absolute and Relative

    • Distribution of factor ownership

    • Distribution of Income

    • Wealth Distribution

    • Discrimination

    • Housing

Market failure17
Market Failure

  • Measures to Correct Market Failure

    • State Provision

    • Extension of property rights

    • Taxation

    • Subsidies

    • Regulation

    • Prohibition

    • Positive Discrimination

    • Redistribution of Income