Introduction to market failure

Market failure 

A recap on markets

For a good in a competitive market: 

Demand is derived from willingness to pay, and so the demand curve slopes downwards as  people are willing to buy more as prices decrease. 

Supply is derived from firms' costs, so the supply curve slopes upwards as firms endeavour to make more money. 

Supply and demand are brought together in a market, where agents exchange goods (and money). 

A market equilibrium (price and quantity at equilibrium), exists where supply and demand meet and no agent has an incentive to offer more or less units at a higher or lower price. 

• In a perfectly competitive market, all agents are price takers, meaning they have no ability to change the market price as each supplier and consumer is small relative to the overall size of the market. 
• The market equilibrium is allocatively 'Pareto efficient', meaning that no-one can be made better off without making someone else worse off. So total welfare (consumer and producer surplus) is maximised at the equilibrium output. 

Five key features of perfect competition 

To do with the producer/consumer relationship: 

1. There are no barriers to entry or exit - so if one wants to join the market or leave, they can do immediately, without having to obtain a license, etc. 
2. There is perfect information - Transparency. All consumers and producers would have the same information, such as each others prices. 
3. There are very many small consumers and producers - so there are no monopolies/monopsonies. 
4. There is no differentiation in output produced - products are uniform. 
5. There are constant/decreasing returns to scale - as a business gets bigger, total costs tend to go up, whereas costs per unit go down, which gives larger firms an advantage over smaller ones, creating a sort of barrier to entry. If returns were constant, so unit cost would stay the same regardless of the scale of the business, this advantage would be eliminated. 

A bonus point is there are no external costs or benefits. So there are no externalities arising form production or consumption. 

Examples

The wheat market is quite close to a perfectly competitive market, as there is little differentiation in the product, and there are very many producers and consumers. However, there is a barrier to entry (land, capital to grow the wheat) and there are increasing returns to scale. 

The high street coffee market is also close to a PCM, as there are few barriers to entry and perfect information. However it is a market dominated by a few larger chains and there is differentiation in the product. 

The foreign trading currency market is somewhere in the middle, as there are barriers to entry (knowledge) and information asymmetry, but there is no differentiation in product. 

The automobile industry moves further still from a PCM, as there are massive barriers to entry, differentiation in the product, and a lot of information asymmetry. 

Furtherest away from the PCM would be the example of London municipal water. It is almost impossible to join this market, as there is a massive barrier to entry: one would have to build a new water system under London. Therefore the returns to scale are huge, there is enormous information asymmetry and only a few main producers. This market is basically a monopoly. 

Market failure
There are a variety of assumptions that lead to perfectly competitive markets producing Pareto efficient (allocation in the most efficient way) outcomes. When some of these assumptions fail in significant ways, we say that the market has failed to maximise welfare.  Some of the ways this happens are: 

• Price-taking is less common in real life markets than in theory due to varying market structures (monopolies, oligopolies, etc.), differentiation in products and advertising. Price-taking is when a firms 'take' prices to match those of their competitors. For example, HSBC has to 'take' an interest rate similar to competing banks in order to remain competitive. In real life, this doesn't happen as much as in PCM, as there are often oligopolies, where a market is dominated by a few large sellers (e.g the coffee shop market). 
• Market participants don't always know key information, such as in cases where haggling is involved, as well as airplane tickets where prices aren't wholly transparent and with insurance where it is hard to know what the value of the product is. 
• Market transactions can impact non-participants. Some examples include pollution as well as pressure on resources. There can also be a positive impact on those no involved. For example, education benefits society positively, or on a more micro scale, painting one's house a bright colour has an impact on your neighbours and those who pass by the house, though they weren't involved in the process. 
• Markets are not possible for all goods. Public goods or services such as free parks and museums would not exist if they were left to the market, as they are built on valuable land which could be used for something more productive such as housing. Other examples are the army and lighthouses - people cannot be prevented from using them if they don't pay. 

There is some deadweight loss (a loss of welfare from consumers, producers, or both) when the market settles at a non-optimal point. 

• For negative externalities and demerit goods, the price mechanism tends to overproduce the goods in question. 
• For positive externalities and merit goods, the market tends to underproduce them. 
• Public goods may not be produced by market mechanisms at all. 
• Monopolies and monopsonies use their market power to redistribute welfare from one party to another, which usually results in deadweight loss as well.