Market Failure

We have said previously that a free market will end up in equilibrium, where supply= demand, due to price mechanism and were all happier ever after. However, there are cases where supply does not equal demand, or it does but, due to side effects, not everyone is happy with what the market is churning out.

Supply= Demand is not in societies best interests.


When a good is produced and consumed, at the free market equilibrium, the seller and buyer are most happy and stable. In this process, however, a third party(not producer or consumer) will be affected by production and/or consumption, who are not accounted for by the market. The effects on third parties are ‘externalities’.

The externality diagram: An extra line is added which shows the external costs or benefits to a given market

Example: Say our ice cream van sells all its stock at £1 per cone, with no demand at that price left unsatisfied. The market says this is the optimum output. However say the van itself makes a lot of noise and pollutes heavily. An External Cost is made by supplying, and society as a whole would be happy with the van turning up less than it actually does. Although it’s the optimum output (for producers & consumers), where 3rd party effects are accounted for less output would be best – To where utility of least valued ice cream = production cost plus external cost.

Types of Goods, the positive side…..

Goods which have overall external costs are de merit goods which society as whole demands a lesser output than the a market turns out(alcohol, drugs, polluting factories). On the positive side some goods yield external benefits or positive externalities to third parties from their production and consumption. For instance, the ice-cream van may play a very nice tune, or increase house prices slightly where it delivers.

In this case, society is pleased with a higher output and complain that the market does not provide enough – the consumer does not value the positive side effects they create meaning too low a supply through the market’s price mechanism.

These are called Merit goods (schools, hospitals, low paid charity work as examples)

One example of a negative externality…

Public Goods

There are certain goods in which there is a social demand, but nobody in the private sector is willing to provide it due to a lack of incentive. These are known in the syllabus as public goods, which have two features which mean there is often no market for it:

  • Non excludability: Anybody passing by can use the good
  • Non rivalry: Use of the good doesn’t reduce the benefit others can get from it

A firework display is close to a public good

Why are public goods missing markets?

Because of non excludability the person buying the good cannot prevent others who have not paid for it from using it as they do. Non rivalry means that the people who don’t pay benefit from the good as much as the buyer does. A recreation ground is an example: Anyone can use it, and benefit highly from it

When this is the case, people generally aren’t willing to pay for the good and with no demand there is no supply.

This is known as the free rider problem – if somebody does pay, the people using it for free are the ‘free riders’, at much annoyance to the person paying.

We end up with no market for something which can benefit lots of people oif it was there: Fireworks displays, recreation grounds, national defense are good examples


Adverse Selection

Adverse selection is where the buyers who need/want the good the most are those people which the sellers are least willing to sell to. Clearly this is a market failure as it is not in society’s best interests where the ones who want a good most are those who are punished and often left out.

Injustice: Examples of where this happens are insurance markets, where a policyholder runs a mile when asked by an 80 year old for life insurance, or someone serving in Afghanistan.

Supply and Demand do not match.

Factor immobility

Factors of production cannot always be moved where they are needed, or there may be a shortage, so there can be very high unmet needs in a market where there is great demand that just cannot be met. Not enough land or labour can be employed to produce what is needed.

Consider the scenario….It is a very hot summer, and of course, there is much demand for ice cream which our vans must meet. However, there is a lack of unemployed who want to become ice cream men(probably a little more ambitious), and maybe not enough freezers can be made. So whatever the demand, the number of ice creams sold from our vans will be limited, and youll just have to go to Tescos or wherever.

Imperfect Knowledge…

‘A scam is a market failure’

People often buy goods they do not really want, whether they are seduced by an advertising campaign or simply are not informed enough to know what is best. In this case, demand is often excessly high for goods which are not as useful as people think they are.

Imperfect knowledge saw billions go into the Madoff fund………

Where people are uninformed, the price mechanism signals to produce more of a good which is not worthy of the factors it takes out for making other things. Think of that useless Christmas scene in Hampshire new forest(UK) and other overhyped products, which have a flood of demand for some time.

Think, this can also be applied to so called overrated or underrated sportspeople, bands and presenters. Imperfect knowledge means too much ‘output’ and profit to some people think are undeserving and vice versa.

Market domination (monopoly).

This is explained well in market structures (‘disadvantage of monopoly’).  Say there is one major firm which dominates a market, and there are few substitutes for the product you want. That dominant firm has lots of bargaining power, and can get away charging a high price to its buyers, making its product very scarce(it only sells to people who REALLY want it, charging a fortune).

Only if you really want it: The demand for the good may be very high, but the dominant firm limits supply to those who really need, and as the firm is much of the market, the market supply remains limited, despite very high price/demand.

What is the market doing, the price mechanism isn’t working! There is high price and the firm just says ‘right, ill take that’ and keeps the price high without supplying more. Outrage.( now you can see the need for regulation of dominant firms with bodies such as OFWAT, OFCOM etc).

Unusual Expectations: Advanced.

Sometimes, supply differs from demand due to varying expectations of firms when thinking how much to produce. They may produce too much expecting huge profits on their investment, or too little. Firms such as Toys R Us will stock what they think people will buy in the future, for instance.

Animal spirits….But the future is impossible to predict and often firms get things wrong. There are the ‘animal spirits’ John Maynard Keynes talked about, that people are often far too optimistic or pessimistic about the future, causing great swings in supply and demand.

The great financier-Economist(and more) George Soros uses this in his ‘reflexivity’ theory, that, even with great information, a market will rest away from equilibrium, and that this explains asset ‘bubbles’ such as houses etc.

The Cobweb Theorum.

‘Another warped expectations market failure’

The legendary 19th century economist David Ricardo created this theory to explain volatile prices in agriculture markets. Supply-price can swing fiercely in such a market where supply is defined by what people think they will recieve some time later when the product is finished(largely governed by future expectation).

How it works: Say a very high price was charged for corn in the last harvest, because it was scarce. Farmers think ‘lets grow lots of corn’ and as a result, much more is supplied, so much more, that it is now very common and a low price. Because of this harvest, farmers will not grow corn, after all, its worth peanuts and because of that it swings back, it becomes scarce again and a high price is recieved.

Volatility, adaptive expectations……..Farmers attracted grow lots and it is common again, low price. This continues again and again, and the market is unstable. In most cases, the farmers(suppliers) become wise to this and start to produce a stable amount, independent of what price they’d recieved(the cobweb is CONVERGING). However, the farmers may just follow this cycle again and again(it may take them time to realise what is happening, aswell as communicate how much to produce is wise).

The Cobweb Theorum: ‘Suppliers supply based upon the price recieved in the previous sale’

One Response to Market Failure

  1. Pingback: My Space. « Zahablog's Economic Page

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