Market equilibrium, the social optimum and the meaning of market failure

Overview

Complete market failure and partial market failure and functions of the price mechanism.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

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.

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