Economics - Market Failure

Types of market failure explained - Unit 1 AS Economics AQA

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  • Created by: Clodagh
  • Created on: 11-04-13 11:16
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  • Types of Market Failure
    • Meaning of market failure
      • It exists where the market/price mechanism leads to the misallocation of resources, because the outcome does not maximise social welfare or benefits
        • TIP: Market failure depends on normative statements (opinions) so you must justify your viewpoint in longer answer questions
      • Complete market failure occurs where no market for a good is provided (a missing market)
      • Partial market failure is where there is a market but it does not allocate resources in a way that maximises social welfare
    • Positive and negative externalities
      • An externality is the effect of an economic decision, such as the manufacture or purchase of a good, on other people or organisations, whose interests were not taken into account
        • A positive externality exists when the effect is beneficial to the outsiders. The social benefit exceeds the private benefit
          • Positive externalities in consumption include vaccination by many consumers leading to less chance of an epidemic affecting others
          • Positive externalities in production include a company training it's workforce and so leading to more wealth creation for society as a whole
        • A negative externality occurs when the action has an adverse effect on outsiders. The social cost exceeds the private cost
          • Negative externalities in consumption include cigarette smoke causing discomfort to non-smokers
          • Negative externalities in production include aircraft noise affecting people who live near an airport
      • The market mechanism does not consider externalities and so market failure arises
      • The demand curve on a graph represents the satisfaction gained by consumers. This is known as the marginal private benefit (MPB)
        • The supply curve of the diagram represents the value of resources used to supply the goods. This is also known as the marginal private cost (MPC)
        • REMEMBER: MSB = MPB + MEB
        • MEC is the marginal external cost, MEB is the marginal external benefit
          • REMEMBER: MSB = MPB + MEB
    • Merit and Demerit goods
      • A merit good is a good that is under provided by the market mechanism
        • Examples include health care and education
          • If left to the free market, these goods would be heavily underconsumed
      • A demeritgood is a good that is over provided by the market mechanism
        • Examples include alcohol, gambling and smoking
      • They arise because consumers do not take into account the externalities involved and they may not actually be aware of the consequences their consumption
      • They are sometimes provided free at the point of use so that consumption doesn't depend on the ability to pay for it
      • The imposition of tax or advertising are ways to solve this market failure
    • Monopolies
      • Monopoly occurs where there is a single supplier in a market. Monopoly power arises where firms exert considerable influence in a market because of their relatively large size. They dominate
      • Causes of monopoly
        • Natural monopoly: It is practical for there to be only one supplier of the product e.g water supply
        • Elimination of competition: Successful firms have taken over competitors or forced them out of business
        • Legal monopolies: Patent laws guaranteeing monopoly status for a number of years, to encourage innovation and invention
        • Local monopolies: The size of the market is too small to support more than one firm e.g a village shop
        • Advertising: Marketing gives monopoly power by creating high brand loyalty so that consumers are reluctant to buuy alternative products
    • Inequalities in income and wealth
      • Income is a flow of money received over a period of time
      • Wealth is a stock of assets accumulated over time, such as ownership of property and cash balances held in the banking system
      • The market mechanism operates on the basis of people offering their skills in return for financial rewards
        • As people's skills differ, incomes vary considerably and so there is inequality in the distribution of income and wealth
          • Wealth inequality is further exaggerated by inheritance of wealth from previous generations
      • Some argue that inequalities represent market failure, as those with lower incomes satisfy fewer wants
    • Immobility of factors of production
      • The market mechanism assumes that resources move automatically to where they are needed most
        • The theory relies on the perfect mobility of labour, meaning the factors of production can easily shift from one use to another
      • Immobility takes two forms...
        • Geographical immobility: Where the resources cannot easily move from one geographical area to another
          • Labour - Workers may not be happy to move away and give up family and friends who live nearby. Regional variations in price also has an impact on low income families
            • Enterprise - Entrepreneurs tend to be more mobile as they are risk takers and can make more money depending on the region of the country
        • Occupational immobility: Where the resources cannot easily move from a particular use or job to another
          • Land - Can often be transferred easily to other uses
          • Capital - It can be adapted for other uses



A full mind map that describes all the types of market failure and the causes of them.

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