Market Failure

MARKET FAILURE In the absence of distortions, competitive equilibrium is efficient. We use the term market failure to cover all the circumstances in which market equilibrium is inefficient. Distortions then prevent the ‘invisible hand’ from allocating resources efficiently. We now list the possible sources of distortions that lead to market failure. Imperfect competition Only perfect competition makes firms equate marginal cost to price and thus to marginal consumer benefit. Under imperfect competition, producers set marginal cost equal to marginal revenue, which is below the price for which the last unit is sold. Since consumer equate price to marginal benefit, maginal benefit exceeds marginal cost in imperfectly competitive industries. Such industries produce too little. Higher output would add more to consumer benefit than to production costs or the opportunity cost of the resources used. Equity Redistribution taxation induces allocative distortions by driving a wedge between the price the consumer pays and the price the producer receives. Externalities Externalities are things like pollution, noise and congestion. One person’s actions have direct costs or benefits for other people but the individual does not take these into account. The problem arises because there is no market for things like noise. Hence markets and prices cannot ensure that the marginal benefit you got from making a noise equals the marginal cost of the noise to other people. Other missing market: future goods, risk and information There are also commodities for which markets are absent or limited. As with externalities, we can’t expect markets to allocate resources efficiently if the market do not exist.1

1

Begg, D., Fischer, S., & Dornbusch, R. (2005). Economics 8th Edition. New York: Mc Graw-Hill Education.