What is Market Failure?

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To understand what market failure is, we first need to look at markets working correctly.

The assumption is that if markets are working freely with no imperfections, this will give the
most efficient outcome, but what does the most efficient outcome actually mean?

Well, if an economy is working efficiently:

1. Firms will be producing at the lowest cost per unit possible (productive efficiency)
2. The economy's resources will be allocated between firms and industries in the most
efficient way (allocative efficiency)

So the economy will be at a point on rather than within its production possibility frontier.

The production possibility frontier (PPF)

A production possibility frontier (PPF) shows all the possible combinations of two mutually
exclusive groups of goods where all the economy's resources are being used and in the most
efficient way possible. It is important that both of those conditions are fulfilled for an
economy to be in a situation on rather than within its PPF.

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Suppose our two mutually exclusive groups of goods are 'military goods' and 'non-military
goods'.

Point A within the PPF represents a situation where:

1. Not all of the economy's resources are being used

2. Or all resources are being used but not at maximum efficiency
3. Or a bit of both.

Let us assume we are at point A and in the second of the three situations above, with all
resources being used (land, labour and capital), but that our military industries are not
presently performing at full efficiency. If this industry were to become fully efficient, it
would be possible to produce more military goods (hopefully as many as M1M2) without
sacrificing any non-military goods. The economy would then move from point A to point B
on the PPF, meaning that the economy would be both productively and allocatively efficient.

Once at point B the economy cannot make more of one type of good without sacrificing the
production of another type of good. If, for example, the economy moved from point B to
point C, the economy would make N1N2 more non-military goods, but at the expense of
M2M3 military goods. This sacrifice is known as the opportunity cost.

The main causes of market failure

Once you understand what market failure is, we need to look at the various reasons why
markets do fail. Below are listed the key reasons why markets fail:

This failure is due to a 'by-product' of a certain production process, or of

Externality consuming something, that affects a third party. This effect can be
positive or negative.
The wrong market This failure is due to the market structure not following the only truly
structure efficient market structure (i.e. perfect competition)
This failure occurs as the goods being produced are of a nature that the
Public, merit and
market would under provide, over provide or even fail to provide, if the
demerit goods
government did not intervene.
Other ways in There are numerous other reasons why markets fail and these are listed
which markets fail further down in this topic.
http://www.s-cool.co.uk/a-level/economics/market-failure/revise-it/what-is-market-failure

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