Market Failure_Part 1

There are several sources of market failure which will be covered in a series of blog posts. For starters, we will focus on market failure arising from externalities. 

• Market failure is defined as the failure of the free market system to allocate resources in an optimum and efficient manner. Hence, societal welfare is not maximized.

Tip: Always remember to define key economics terms, especially if you are unsure of how to start your answer.

• Define negative externality: External cost of production (or consumption depending on scenario) accrued to a third party uninvolved in the transaction between the buyer and seller. 

Tip: Formulate your answer in the context of the question by stating specifically what these external costs are through examples

                                                              Figure 1. 

Tip: In A level economics, using a framework and graphical analysis is very important. However, graphs are insufficient on their own so further elaboration is needed, while making references to the diagrams drawn.

Tip: Diagrams have to be well-labelled! 

• Define the following in the context of the question: Marginal external benefit (MSB), Marginal private benefit (MPB), Marginal external cost (MEC), Marginal private cost (MPC)
• Important assumptions to state: Perfect competition and absence of positive externalities (These assumptions are made in order to explain market failure arising from negative externality)
• State that due to the pursuit of self interest, producers manufacture the good (if the external cost arises from consumption, this previous statement should be changed to ‘consumers buy the good’) up to the point where MPB = MPC
• State that allocative efficiency is achieved at the point where MSB=MSC
• Due to the presence of negative externality, there is a divergence between MSC and MPC (represented by the gap between MSC and MPC, which is also equivalent to MEC)
• As a result, there is overconsumption of the good by (Q₁ – Q_E) units. The area of deadweight loss is represented by shaded area in the diagram.
• Since society’s welfare is not maximized, market failure has occurred.

*The explanation for market failure arising from positive externality follows a similar structure. Try it out for yourself!

Look out for more explanations other sources of market failure in the future!