Overview
This lesson introduces market failure, its definition, causes, and related concepts like productive and allocative efficiency, which are important for understanding why markets sometimes fail to allocate resources optimally.
What is Market Failure?
- Market failure is when markets fail to achieve optimum resource allocation.
- It occurs when there is either oversupply or undersupply of products.
- Optimum allocation means the exact right amount of a product is produced and consumed.
Types of Efficiency
- Productive Efficiency: Achieved when goods are produced at maximum output from given resources, typically on the production possibility curve.
- Firms operating inside the curve are productively inefficient; points outside the curve are impossible.
- Allocative Efficiency: Achieved when the optimal mix of goods and services is produced to maximize consumer satisfaction, shown by the indifference curve.
- The best combination is both productively and allocatively efficient.
Causes of Market Failure (MILIIE)
- Missing Markets: Some goods (mainly public goods) are not provided because conditions for the market do not exist.
- Imperfect Markets: Imperfect competition (e.g., monopoly, oligopoly) cannot achieve efficiency like perfect competition.
- Externalities: Costs or benefits affecting third parties not involved in the transaction, can be positive (e.g., beekeeping and orchards) or negative (e.g., secondhand smoke).
- Lack of Information: Producers or consumers lacking accurate information may cause over- or underproduction.
- Imperfect Distribution of Income and Wealth: Unequal distribution leads to inefficient allocation and reduced access.
- Immobility of Factors of Production: Labor and physical capital may not move to where they are needed, limiting optimal production.
Key Terms & Definitions
- Market Failure — When a market does not allocate resources optimally.
- Productive Efficiency — Producing goods at the lowest cost with maximum output from resources.
- Allocative Efficiency — Producing the mix of goods most desired by consumers.
- Public Goods — Goods that are non-excludable and non-rivalrous (e.g., streetlights).
- Externalities — Costs or benefits affecting third parties outside a transaction.
- Immobility — Inability of labor or capital to move to where needed.
Action Items / Next Steps
- Review activity 70: Define market failure and explain economic inefficiency as a consequence.
- Memorize the causes of market failure using the mnemonic "MILIIE".
- Reread sections on productive and allocative efficiency for understanding.