Causes of market failure: missing markets

Efficiency and Market Failure – Missing Markets

1. Objective

• Explain why a market may be missing (or incomplete) and how this creates market failure.
• Analyse the welfare loss that arises when a market is absent.
• Identify the four main sub‑categories required by the Cambridge AS & A‑Level syllabus.
• Evaluate government policies that create or mimic missing markets and recognise possible government failure.

2. What is Market Failure?

A market failure occurs when the free market does not allocate resources efficiently, resulting in a loss of total welfare (dead‑weight loss, DWL).

Allocative efficiency – private market

In a perfectly competitive market the condition for allocative efficiency is

$$ P = MC_{private} $$

where P is the market price and MC_private is the marginal cost borne by the producer.

Allocative efficiency – with externalities

When a transaction creates external costs or benefits the socially optimal condition becomes

$$ MSB = MSC $$

with MSB = marginal social benefit and MSC = marginal social cost. If the market only satisfies P = MC_{private} while MSB ≠ MSC, a market failure exists.

Intuitive picture of DWL

The dead‑weight loss is the “missing” benefit (or extra cost) that society could have enjoyed if the market had operated at the socially optimal quantity. It is the area between the marginal social benefit and marginal social cost curves that is not realised because the market is absent or distorted.

3. Missing Markets – Definition

A missing (or incomplete) market exists when there is no market for a good, service or right that would increase overall welfare if it could be traded. Typical reasons are:

• Property rights cannot be defined or enforced.
• Transaction costs are prohibitively high.
• Uncertainty about future states of the world (risk).
• Information asymmetry that prevents mutually beneficial trades.

4. Syllabus‑required Types of Missing Markets

Missing‑Market Category	Key Characteristic	Typical Example	Why the Market Is Missing
Positive Externalities	MSB > MPB (marginal private benefit)	Vaccinations, basic education, R&D	Beneficiaries cannot be forced to pay; producers cannot capture the full benefit.
Negative Externalities	MSC > MPC (marginal private cost)	Factory emissions, second‑hand smoke	Producers do not bear the full cost; victims cannot be compensated easily.
Public Goods	Non‑rival & non‑excludable	National defence, street lighting, lighthouse service	Free‑rider problem prevents voluntary provision.
Merit / Demerit Goods	Private benefit/cost diverges from social benefit/cost	Merit: primary education, health care; Demerit: tobacco, alcohol	Consumers underestimate (merit) or overestimate (demerit) the social effects; market price does not reflect MSB or MSC.

5. How Missing Markets Lead to Market Failure

• Under‑provision of socially beneficial goods – Quantity supplied is zero even though MSB > MC. Example: vaccinations, basic education.
• Over‑production of harmful goods – Firms produce where P = MC_{private} while MSC > MSB. Example: unchecked factory emissions.
• Inefficient risk allocation – Absence of insurance forces individuals to face uncapped losses, reducing expected utility.
• Misallocation due to information gaps – Asymmetric information prevents mutually beneficial trades, leading to adverse selection or moral hazard.
• Merit/Demerit goods mis‑pricing – Private price reflects only private marginal benefit/cost, causing too little merit‑good consumption and too much demerit‑good consumption.

6. Welfare Analysis of a Missing Market

Assume a good would be supplied if a market existed (e.g., a public good). The socially optimal quantity Q* satisfies

$$ MSB = MSC $$

If the market is missing, the actual quantity is Q = 0. The dead‑weight loss is the area between the MSB and MSC curves from 0 to Q*:

$$ \text{DWL}= \int_{0}^{Q^{*}} \bigl(MSB - MSC\bigr)\,dQ $$

Graphically this is a triangle with base Q* and height MSB_{0} - MSC_{0}. The shortcut formula is therefore

$$ \text{DWL}= \frac{1}{2}\,(P_{MSB} - P_{MSC})\,(Q^{*}) $$

For a positive externality the triangle lies **above** the private‑benefit curve; for a negative externality it lies **below** the private‑cost curve.

7. Government Policies to Correct Missing Markets

Policy	How It Works	Advantages	Disadvantages / Potential Government Failure
Direct provision of public goods	Government produces and finances the good via taxation.	Eliminates free‑rider problem; ensures universal access.	Risk of over‑provision, bureaucratic inefficiency, fiscal burden.
Subsidies (positive externalities, merit goods)	Payment to producers or consumers to lower the effective price.	Encourages higher consumption/production; relatively easy to target.	Cost to the exchequer; possible DWL if subsidy exceeds marginal benefit; rent‑seeking.
Taxes (negative externalities, demerit goods)	Charge per unit of output or consumption equal to marginal external cost.	Internalises external cost; generates revenue.	May be politically unpopular; can create black markets; administrative complexity.
Tradable permits (e.g., emissions trading)	Allocate a total cap and let firms buy/sell permits.	Achieves the required quantity at lowest cost; creates a market where none existed.	Initial allocation can be contentious; monitoring and enforcement needed.
Regulation & standards	Set minimum quality, safety or emission standards.	Reduces information asymmetry; protects health and safety.	Can be inflexible; compliance costs may be high; may stifle innovation.
Compulsory insurance (e.g., motor vehicle)	Legal requirement to purchase insurance.	Ensures risk is pooled; prevents catastrophic losses.	May impose a burden on low‑income households; risk of moral hazard.

8. Government Failure – When Intervention Worsens Welfare

• Policy distortion: taxes or subsidies set at the wrong level, creating new DWL.
• Rent‑seeking: interest groups lobby for favourable treatment, leading to inefficient allocation.
• Regulatory capture: regulators act in the interest of the industry rather than the public.
• Information problems: governments may lack the detailed data needed for optimal rates.
• Fiscal constraints: high public spending can crowd out private investment.

9. Suggested Diagram

10. Summary Checklist for Exams

• Identify the type of missing market (positive externality, negative externality, public good, merit/demerit good). Optional: insurance or information markets.
• State the relevant allocative‑efficiency condition:
  • Private market: P = MC_{private}
  • With externalities: MSB = MSC
• Sketch the appropriate diagram:
  • Label MSB, MSC (or private MB/MC) and the dead‑weight‑loss triangle.
  • Show the socially optimal quantity Q* and the actual quantity (0).
• Calculate DWL if numerical data are given, using the triangle formula $$\text{DWL}= \frac{1}{2}\,(P_{MSB} - P_{MSC})\,(Q^{*})$$
• Recommend a government policy and evaluate it in terms of:
  • Effectiveness – does it move the market toward the social optimum?
  • Efficiency – size of any new DWL created.
  • Equity – who gains or loses?
  • Risk of government failure – rent‑seeking, distortion, capture, information gaps.