Market Failure — Hyunjoo Park

Definition

A market fails when decentralised market decisions do not produce an efficient allocation: $Q_{Market} \ne Q_{Social}$ Benchmark = Perfect Competition ( $P = MC$ , total surplus maximised → Allocative vs Productive Efficiency).

Market failure ≠ undesirable market outcome

An undesirable outcome (e.g. high prices, inequality) is not a market failure by itself. It is a failure only if a mechanism stops the market from reaching the efficient allocation. (Efficiency ≠ equity → Policy Goals)

Mechanism = a specific cause (one of the seven below) that pushes $Q$ away from the efficient level. Example: High electricity price cause -> mechanism

Cold, windless week: scarcity, price rations power -> No market failure, just unpleasant
One generator withholds capacity -> Market power ( $P > MC$ ), leading failure

Seven causes

Source	Mechanism
Externalities	effects on third parties not in the price
Public Goods	free riding → $Q_{Market} < Q_{Social}$
Asymmetric Information	adverse selection, moral hazard
Market Power	$P > MC$
Network Effects and Coordination Failure	network effects: value depends on others / my best choice depends on yours coordination failure: multiple equilibria, stuck in low-investment equilibrium
Missing / incomplete markets	a relevant cost or benefit has no market price (e.g. no carbon price → emissions unpriced)

One market failure ≠ one whole transition problem

Failures can overlap. Correcting one distortion does not guarantee the first-best → Theory of the Second Best.

First-best vs second-best

First-best: every failure fixed, ideal outcome (usually unreachable)
Second-best: best outcome when some failures can’t be removed
Fixing one failure as if the others didn’t exist can make things worse → design the fix with the remaining distortions in mind
e.g. polluting monopolist: produces too little (market power) but pollutes (too much). A Pigou tax (tax = pollution damage per MWh) would be perfect in a competitive market, but here it cuts the already-too-low output even further. When the monopoly can’t be fixed, a smaller tax than the Pigou tax gives a better result → that smaller tax is the second-best policy

Links: W2.1 Market Failure