Market Failure (AS/A2 Macroeconomics)

Market failure refers to a situation in which a market fails to operate efficiently, hence the title ‘Market Failure’. There are two kinds of efficiency; allocative efficiency, which occurs when the market provides the desired quantity of the products in high demand, it is illustrated by when Price=Marginal cost, as shown on the diagram for perfect competition. Productive efficiency is the second type and this requires production to be at the lowest cost and is shown by production to be at the lowest point of the average cost curve. The result of market failure is a loss in economic and social welfare.

There are a number of examples of market failure that can be taken from AS principles, such as externalities. Products with negative externalities have a negative effect on a third party and cause the social cost to be higher than the private cost, in other words the price is lower than the cost of the implications consumption has. Negative externality markets demonstrate market failure as the wrong number of goods are supplied causing a loss in social welfare.

A situation where information failure is present is a second example of a failing market. When consumers are not fully aware of the benefits of merit goods they have a lower level of demand than what they would if there was perfect information and they were fully aware of the benefits they will receive through use or consumption of the good. The consequence of this is the loss in social welfare that consumers could potentially achieve if they had full information.

An example can also be taken from the A2 market typologies, this would be a market experiencing the dominance of a monopoly. This is because theory suggests that monopolies under produce, therefore purposely creating scarcity, to ensure high prices and as a result not providing allocative efficiency.  Also monopolies fail to achieve productive efficiency as they do not operate at the lowest point of the average cost curve. This is due to the lack of competition, monopolies don’t have to compete on price so will maximise profits with high profit margins through high prices rather than encouraging productivity to drive down costs.

The market of perfect competition is a market that provides both allocative and productive efficiency.  This is because there are so many buyers and sellers that competition is so intense that any firm operating above the most productive output will go out of business as there is only room for businesses making normal profits under perfect competition. Allocative efficiency is also seen to be achieved as price is equal to marginal cost, however, perfect competition is criticised for being idealistic as it is almost impossible to re-create in the real world. Therefore, for a market to be judged to be operating efficiently it can be compared with the characteristics of perfect competition as that is the most efficient market.