Types of Market Failure

The price mechanism, or the “invisible hand”, is incredibly efficient in allocating resources.

At equilibrium, there’s no excess demand or excess supply, what sellers are trying to sell precisely matches what buyers are trying to buy – it’s really quite beautiful.

And even better, the consumers do who buy are these consumers here, all the way up to the equilibrium quantity, they’re the consumers who are willing to pay the highest prices for the good! 

In other words, they’re the consumers who get the most benefit from the good, they value it most – and the price mechanism, as if by magic, makes sure that they’re the consumers who receive the good!

Equally, the producers who sell are these producers here, they’re the producers who are willing to sell the good for the lowest prices!

In other words, they’re the producers with the lowest costs of production, that’s why they’re willing to sell at lower prices… and the price mechanism ensures that they’re the producers who actually sell, which means the good is produced at the lowest costs possible!

Economists call this allocation efficient. Those who benefit most from the good get to buy it, those who can produce the good at the lowest cost are the ones who sell it… and there’s no excess demand or supply in the market.

BUT the market is sometimes inefficient. Sometimes, there’s market failure: 

Market failure is when the price mechanism leads to a misallocation of resources

That means that the price mechanism leads to a price and quantity that isn’t best for society… and there are four reasons we’ll look at to explain why this might happen:

1. negative externalities 
2. positive externalities 
3. publics goods
4. information gaps

We’ll be looking at each of these in turn! And we’ll then see how the government can intervene in these markets, using policies like taxes and subsidies, to correct the market failure to make everything efficient again.