Market Failures and Imperfections

What Market Failures and Imperfections covers

Market failures and imperfections is examined in Unit AS 1, Markets and Market Failure. It covers market equilibrium, the social optimum and the meaning of market failure, externalities: private, external and social costs and benefits, community surplus and the externality diagrams, calculating and interpreting welfare loss, public goods, quasi-public goods and the free rider problem, the consequences of missing markets for public goods, merit goods and demerit goods, information gaps and asymmetric information, the consequences of merit goods, demerit goods and information failure, market power and other market imperfections, income and wealth inequality and absolute and relative poverty.

The 12 subtopics

Each one has its own page.

• Market equilibrium, the social optimum and the meaning of market failureComplete market failure and partial market failure and functions of the price mechanism.Open →
• Externalities: private, external and social costs and benefitsExternality and explain what makes it external, production externality and a consumption externality and claim that all negative externalities should be eliminated entirely.Open →
• Community surplus and the externality diagramsConsumer surplus.Open →
• Calculating and interpreting welfare lossWelfare loss triangle vanish at the socially optimum quantity.Open →
• Public goods, quasi-public goods and the free rider problemNon-excludability using street lighting, free rider problem and differences between a private good and a pure public good.Open →
• The consequences of missing markets for public goodsConsequences of the free rider problem for firms, consequences for government of public goods being non-excludable and consequences for third parties.Open →
• Merit goods and demerit goodsMerit good.Open →
• Information gaps and asymmetric informationInformation gap and information asymmetry, adverse selection and moral hazard.Open →
• The consequences of merit goods, demerit goods and information failureConsequences for government of persistent over-consumption of demerit goods, consequences of information failure for producers and moral hazard affect the cost of insurance for careful customers.Open →
• Market power and other market imperfectionsMarket power, productive inefficiency and barriers to entry.Open →
• Income and wealth inequalityIncome and wealth, wealth typically distributed more unequally than income and gini coefficient measure.Open →
• Absolute and relative povertyAbsolute poverty, relative poverty and equivalisation used when measuring poverty.Open →

What you need to know

Answer each one before you reveal it.

Take Market Failures and Imperfections further

The same content, four other ways.

Commonly confused

Pairs that lose marks when they are blurred together.

• Non-excludability vs Non-rivalry

  Non-excludability: non-payers cannot be kept out, which destroys the ability to charge. Non-rivalry: one person's use leaving the amount available to others unchanged.

• Complete market failure vs Partial market failure

  Complete market failure: no market exists and output is zero, as with a pure public good. Partial market failure: the market operates and output is positive.

• The mean vs The median

  The mean: the total divided by the number of observations and is pulled towards extreme values. The median: the middle observation, which is not pulled towards extreme values.

Questions from this topic

Each one with the model answer underneath.

1. 1

   Why can a free market settle at a quantity that is not the best one for society as a whole?

   Model answer

   The free market equilibrium is set where private demand meets private supply, so it reflects only the costs and benefits felt by the buyers and sellers themselves. If production or consumption imposes costs on third parties, or confers benefits on them, those effects never enter the price signal. The market therefore equates marginal private benefit with marginal private cost rather than marginal social benefit with marginal social cost, and settles at a quantity above or below the socially optimum one.

2. 2

   What condition has to hold at the socially optimum level of output?

   Model answer

   Marginal social benefit must equal marginal social cost. At that quantity the value society places on one more unit is exactly equal to what society gives up to produce it, so no reallocation of resources can raise total welfare. Producing beyond it adds more to social cost than to social benefit; producing less leaves net benefit unrealised. This is the allocatively efficient point, and it is where the welfare loss triangle disappears.

3. 3

   Distinguish between complete market failure and partial market failure.

   Model answer

   Complete market failure means the market does not supply the good at all, so a missing market exists; a pure public good such as street lighting is the standard case, because non-excludability makes it impossible to charge. Partial market failure means the market does function and a price is charged, but resources are misallocated, so the quantity traded lies above or below the social optimum. Pollution from a factory and under-consumption of vaccination are examples of partial failure.

4. 4

   A market is described as allocatively efficient. What does allocative efficiency actually require?

   Model answer

   Allocative efficiency requires that resources produce the combination of goods society most values, which occurs where price equals marginal cost, or equivalently where marginal social benefit equals marginal social cost. Community surplus is then at its maximum. In a competitive market with no externalities and full information the free market equilibrium delivers this. Once externalities, market power or information failure are present, the market outcome no longer satisfies the condition.

5. 5

   Why is market failure not the same thing as a market having collapsed?

   Model answer

   Market failure means the price mechanism misallocates resources, not that trade has stopped. In most cases the market works perfectly well as a mechanism and simply produces the wrong quantity: too much of a good carrying external costs, too little of one carrying external benefits. Only in the extreme case of a missing market, such as a pure public good, does the market genuinely fail to appear at all.

6. 6

   Third parties bear costs from a factory's production but take no part in the transaction. Why does the price mechanism take no account of them?

   Model answer

   Prices are formed by the bids of buyers and the offers of sellers, and each side considers only its own costs and benefits. A third party is by definition not a participant in that transaction, so their loss never appears as a demand or supply decision. Without property rights that let them charge for the damage, the external cost stays outside the price. The signalling and incentive functions of price therefore transmit incomplete information.

What is inside Levo

Six ways to work the same material.

Market Failures and Imperfections revision questions

What does Market Failures and Imperfections cover in CCEA A-Level Economics?

12 subtopics: market equilibrium, the social optimum and the meaning of market failure, externalities: private, external and social costs and benefits, community surplus and the externality diagrams, calculating and interpreting welfare loss, public goods, quasi-public goods and the free rider problem, the consequences of missing markets for public goods, merit goods and demerit goods, information gaps and asymmetric information, the consequences of merit goods, demerit goods and information failure, market power and other market imperfections, income and wealth inequality and absolute and relative poverty. Each one has its own page with questions and model answers.

How is Market Failures and Imperfections organised?

By the CCEA 4410 specification, subtopic by subtopic, so it matches the order you are taught it in.