Market Failure Economics Essay Outline

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Market failures

Market failures arise when free markets fail to develop, or when they fail to allocate resources efficiently. There are several different types of market failure.

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Markets can fail in two basic ways:

A complete failure

A complete market failure exists when free markets are unable to allocate scarce resources to the satisfaction of a need or want. This occurs because there are insufficient incentives to encourage profit-seeking firms to enter a market. This is commonly the case with pure public goods, such as street lighting, for which there is a need, but private individuals would not be prepared to pay. If no-one is prepared to pay, no revenue can be derived, and no profit earned; hence no firm would enter the market.

A partial failure

A partial failure can occur in four ways:

  1. When some, but not all, of the necessary conditions for market formation exist.  This means that markets form, but will fail to develop and supply sufficient quantities of a good or service. In the case of merit goods, such as education, markets are inefficient because they under-supply these goods, and fail to meet society’s demand.

  2. When free markets over-supply a good or service, either because producers fail to take into account the full costs of production to society, or because consumers fail to take into account the full costs of consumption to themselves, or society. Externalities and demerit goods are cases of free markets over-supplying.

Go to: Types of market failure 


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Perfect Competition and Efficiency

Perfect Competition is an ideal market structure (theoretical structure) primarily utilized as a standard to existing (real) market structures. This is sometimes called “pure competition.” This market structure is characterized as follows: 1) all firms basically produce and sell similar products; 2) all firms are subjected to the prevailing market price; 3) all firms have a small, almost uniform market share of a particular product; 4) buyers have complete information of the nature of the product sold as well as its corresponding price; and 5) firms have the freedom to enter and exit market (Perfect Competition, 2007). In perfectly competitive market, when a single firm decided to increase the price of a particular good, consumers will naturally shift their expenditure schedule (for that product) to firms selling the same product at a lower price.

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Corollary to that, if a firm decided to decrease the price of a particular good, in order to capture a significant portion of the consumer’s income, the firm will be left earning profit less than the earnings of firms offering the same product at a higher price (market price). This is so since all firms in this market structure have a small portion of the product’s market share. This relationship between price and the relative market share of firms for a particular product is facilitated by of complete dissipation of knowledge of market prices (and the nature of products sold in the market) to consumers. If a firm raises the price of its product, the consumer can easily “turn-around” to firms selling the same product at a lower price. Thus, the firm (which offered a price higher than the market/equilibrium price) loses its market share for a particular product (forcing it to exit the market).

Thus, it can be said that in perfect competition, price is constant (horizontal line represented as the demand curve). The volume of goods bought by consumers is unaffected by price increases. The firms receive an almost equal proportion of the consumers’ income. The overall profit in the short-run are almost fixed for each firm. If the demand schedule of consumers increase (maybe because of a change in taste or preference or a change in consumer expectation), the price also increases. Here a new level of market equilibrium is achieved. Firms supplying a particular product will negotiate with consumers for a new price level. After the price negotiation, a new fixed price level is established (in the long-run).

Inherent in perfectly competitive market is its theoretical adherence to efficiency. Efficiency can be roughly defined as the condition of balanced welfare surplus; that is, the goods produced in the market are transferred through transactions to potential consumers. Efficiency is of two types: allocative efficiency and productive efficiency. Allocative efficiency can be defined as “the guiding principle of modern economic policy when all mutually beneficial trades have been made, and all the goods are in the hands of those who value them most” (Kaiser, 2007). Productive efficiency is the condition where there is the assurance that “whatever is being made is produced in the most efficient manner, that is, no change in the mix of inputs would result in increased output, given the current technological constraints” (Kaiser, 2007). Here what is given primacy is allocative efficiency (in relation to perfect competition).

In a perfectly competitive market, welfare surplus is the volume of potential welfare (in terms of goods and services) directed to potential consumers. Deadweight loss is the opposite of welfare surplus. It is the potential welfare surplus converted to a firm’s profit because of inefficiencies in the market. In an ideal state of affairs, deadweight loss is zero because the market (which is perfectly competitive) offers a fixed price for particular goods. Hence, the marginal rate of substitution is identical for all consumers. No consumer can be better off without making the other worse off.

This leaves all the consumers achieved what economists call the “Pareto efficiency.” In practical terms, it is a measure of welfare, a condition where an inpidual can be made better without making another worse off. This is generally an extension of the concept of welfare surplus. Thus, in a perfectly competitive market, all the potential consumers are theoretically satisfied of the transactions in the market (increased welfare surplus). Allocative efficiency serves as a means to increase welfare surplus.

Sources of Market Failure: The Imperfect Markets

There are different types of imperfect markets. When only one firm is producing/selling a particular product to potential consumers, it is called monopoly (a monopsony is market structure in which there is only one buyer of a particular product). Because entry into a particular market or industry corresponds to high costs and other impediments, the market is left with only one producer of a particular product. Monopoly though is not necessarily bad. There are certain industries in the economy that are monopolized for economic reasons. For example, monopolizing the power industry would prove efficient both for the government and the consumers. It is often embarrassing to the eye of a consumer to see different electric posts owned and run by different power companies.

Monopoly though becomes inefficient if the firm produces less goods/services from that demanded by potential consumers. This generally results to an increase of price of the particular good/service. This increase in the price of a certain good also results in the reduction of welfare surplus. A portion of the welfare surplus is converted to the firm’s profit. Hence, in this type of market, the amount of potential welfare surplus depends largely on the price dictated by the firm (since consumers have no alternative, the power to dictate price changes rests on the single firm).

Added to that, consumers often do not have complete information (imperfect information) of the internal workings of the firm; the cost of production, expected revenues, profit level, and the most important, the volume of goods produced. Needless to say, in this type of market structure the firm controls the amount of goods produced to enable it to dictate prices.

When only few firms are selling/producing a particular product to potential consumers, it is called oligopoly. This group of firms usually has control over the price of a particular product. Entry to the market becomes impermissible because of high costs and other impediments. So in order to maintain the market profit of each firm, an economic reaction from a particular firm will be imitated by other firms. So if firm Y increased the price of its product by 11%, firms X and Z (in the same industry) follow suit. If firm Z decreased the price of its product by 13 %, firms X and Y will approximately decrease the price of its product by 13%.

Unlike the perfectly competitive market, oligopoly rests on the assumption of economic collaboration. A group of firms in the same industry can virtually increase gradually the price of a particular product. Consumers are left without protection from these unwarranted price increases (thus, many governments institutionalized the so-called anti-trust policy to protect consumers from unwarranted market behavior of some firms).

Thus, both monopoly and oligopoly result in both allocative and productive inefficiency. The market is flooded with price increases without an overall increase in the volume of goods/services offered in the market. Added to that, because entry to the market is difficult, capital becomes stagnant (concentrated to few firms). Nonetheless, the creation of more public goods (from the taxes of firms) of the government can be severely threatened. Since most governments use the so-called “specific taxes” (tax per unit of good produced), a general decrease in the volume of goods/services offered by a particular industry results to an overall decrease in government income.

In the case of externalities (externalities are of two types: negative externalities and positive externalities – the former is a market structure with negative spillover effects on others – the latter is a market with positive spillover effects on other), market price of major industries becomes unpredictable in the long-run. In a May 1996 issue of the Wall Street Journal (entitled Economists Say Gasoline Tax Is Too Low), economists argued because of the unpredictable behavior in the long-run of oil prices in the world market, the US government was forced to keep the gasoline prices low (Calmes and Georges, 1996). This instance enabled oil companies to double their revenues at the expense of the consuming public.


  • Calmes, Jackie and Christopher Georges. (1996). May 7 Issue The Wall Street Journal.
  • Economics Basics: Monopolies, Oligopolies and Perfect Competition. (2007). Investopedia. Retrieved on October 23, 2007 from
  • Kaiser, Hanno. (2007). The Goals of Antitrust and Economic Policy: Consumer Welfare? Efficiency? Perfect Competition? Retrieved on October 23, 2007 from http://
  • Perfect Competition. (2007). Investopedia. Retrieved on October 23, 2007 from http://


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