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1.4 Market failure

Syllabus: Examine the concept of market failure as a failure of the market to achieve allocative efficiency, resulting in an over-allocation of resources (over-provision of a good) or an under-allocation of resources (under-provision of a good)

What is Economics? By now you should be able to recite this answer without thinking.

How are Resources Allocated? Can you answer this? Make sure you can before proceeding

In general markets allocate resources to their best use - without any authority (eg Government, Trade Union, Employer Association etc)

telling anyone in the market what to do (ESEPME again). This is one of the main arguments made in Adam Smith´s The Wealth of Nations. What drives the efficient allocation of scarce resources in most markets is self interest of producers and consumers both trying to maximise their own benefits in transactions. In other words the forces of Demand and Supply operate to maximise social welfare.

However in certain markets Demand and Supply distort the allocation so that community benefit is not at a maximum (see previous learning on Market Efficiency Page 47).

The main reasons why markets fail to do this can be listed as follows:

  • Asymetric Information
  • Negative and positive externalities (Merit Goods and Demerit Goods)
  • Sustainability
  • Public Goods
  • Monopoly Power (dealt with in Theory of the Firm)
You need to know these in detail and also how Government and regulation can meet these challenges