Why Market Economy Fails (Part 1)

It is well known that when quantity supplied equals to quantity demanded (Q_S = Q_D), the market is in equilibrium - there is an optimal resource allocation. Should the market not achieved this equilibrium market has failed.

However, in practice, firms and households make choices governing the allocation of factors of production (F.O.P) that they own and try to answer to the problems of what, how, and for whom to produce, taking into account only their cost and benefits (self interest)[1]. Thus they ignore others (society) - external costs and benefits, e.g. pollution to the atmosphere

In other words, resources (F.O.P) are not used (allocated) in the best possible option (efficiently) in the sense that none of them are wasted[2] (society’s point of view).

The efficient allocation of resources occurs if resources are used in such way that it would not be possible to use them in a different way to make someone better without making someone else worse off. (Pareto’s efficiency - Market failure/Negative externalities)

Market fails because market mechanism (equilibrium D+S) fails to take into account all the external costs and benefits in providing and /or consuming the goods. As a result market fails to supply the socially optimal amount.

The competitive market forces (D+S) will not produce the quantities of goods where the price (P) reflects the marginal benefit (utility) of consumption. This in turn leads to over/under consumption of the goods, e.g. allocate inefficiency.

Social efficiency arises when MSB[3] = MSC[4]. As soon as, MSB › MSC or MSB ‹ MSC market failed since, either too much or too little is being produced.

Consequently the market economy (absence of the government) would fail to achieve an efficient allocation of resources.

Reasons for market failure:

1. Existence of externalities (positive and negative). External benefits and costs, i.e. pollution.
2. Short-term and long-term environmental concerns, with reference to sustainable development.
3. Lack of public goods
4. Under provision of merit goods (i.e. health care)
5. Over provision of demerit goods
6. Abuse of monopoly power
7. The lack of information, that is available to people when they make their choices.

[1] Adam Smith (1776), Invisible hand – billions of individual transactions would together create a system where the right goods were produced in the right amounts.

[2] If firms did not produce their output at the min possible cost, then it is using more resources that is necessary (waste).

[3] Marginal Social Benefit in the production/consumption

[4] Marginal Social Cost in the production/consumption