Definition of market failure

The Allocation of Resources – Market Failure

Objective

To be able to define market failure and recognise the situations in which it arises.

Definition of Market Failure

Market failure occurs when the free market, left to operate without government intervention, does not allocate resources efficiently. In such a situation the total welfare of society is lower than it could be, because the quantity of a good or service produced and consumed is not the one that maximises the net benefit to society.

Why Efficient Allocation Matters

In an efficient market the marginal benefit (MB) to consumers of the last unit produced equals the marginal cost (MC) to producers of that unit:

\$\$

\text{MB} = \text{MC}

\$\$

If MB > MC, society would be better off producing more of the good; if MB < MC, producing less would increase welfare. Market failure means this equality does not hold.

Common Causes of Market Failure

• Externalities – costs or benefits that affect third parties not involved in the transaction.
• Public Goods – goods that are non‑rivalrous and non‑excludable, leading to under‑production.
• Information Asymmetry – one party has more or better information than the other, causing inefficient decisions.
• Market Power – monopolies or oligopolies can restrict output and raise prices above competitive levels.

Summary Table

Suggested Diagram

Key Points to Remember

1. Market failure means the market outcome is not Pareto‑efficient.
2. Government intervention (taxes, subsidies, regulation, provision of public goods) is often justified to correct the failure.
3. Identifying the type of failure helps decide the most appropriate policy response.