Defining Market Failure3 min read

how do you define market failure? if i were to say that market failure refers to the free market being unable to achieve economic(allocative and productive) efficiency in the absence of govt intervention then for the case of income inequality, is it considered a market failure? (given that the market does allocate resources efficiently except that it isn’t a satisfactory allocation. :/

Defining Market Failure

Market failure in the H2 context specifically refers to the unfettered free market failing to achieve allocative efficiency. In most other contexts (including at the university level), market failure refers to the free market failing to achieve pareto efficiency. If we follow the latter definition, then income inequality DOES NOT lead to market failure.

Wealth Inequality & Market Failure

But now let’s go a bit deeper on the income inequality issue. In fact, it is far more likely that market failure arises from wealth inequality than from income inequality. (People often fail to distinguish the two.) Wealth inequality can lead to market failure because of how allocative efficiency is defined. The argument is nuanced and I think it is not required at the A Levels. Some schools still choose to teach it, but it is usually not well articulated.

Allocative v.s. Pareto Efficiency

First we have to understand that allocative efficiency is a subset of pareto efficiency. Pareto efficiency is a situation when no one can be made better off without someone being made worse off. Allocative efficiency is when society’s welfare is maximised. In other words, only one pareto efficient point is allocative efficient.

Economics and Ethics

Second, we have to understand that allocative efficiency assumes that we have a way to measure welfare. We arrive at welfare when we find a way to rank the different combinations of utility achieved. We like to think that economics is divorced from ethics and politics, but that’s not the case. When we measure welfare, we are imposing some assumptions on what is better for society. Usually we assume this idea of utilitarianism — what is best is what maximises utility. But it is not hard to see that there might be other possible ways of measuring welfare. For example, an egalitarian approach, where it is better if people are treated the same/ receive the same amount of utility.

An Example

To see how wealth inequality, under an assumption of utilitarianism might lead to market failure, consider the case where one person owns all the wealth in the economy. This is still a pareto efficient allocation because it is not possible to make someone better off without making this one person slightly worse off. But is it allocative efficient? Assuming that utility curves are diminishing in marginal utility, i.e. the more you consume, the less satisfaction each additional unit of consumption brings you, it is not hard to see how we might increase society’s utility by redistributing some wealth to the poor. The increase in utility to the poor will outweigh the fall in utility to the rich fat guy.

Why does it matter that we even bring in utilitarianism, you might ask? Because suppose to our society, what’s good is that we maximise the welfare of the ruler and nothing else matters. Then under this assumption, the outcome is allocative efficient. A more nuanced reason will be that utilitarianism does not necessarily favour an equal distribution of wealth (i.e. some wealth inequality may still be desirable) whereas other ways of ranking like egalitarian or Rawlsian will favour a more equal distribution.

In summary

If all that went over your head, not to worry because it’s not important at the A Levels. In fact, I am not 100% sure that I explained it without any errors, but it’s basically what I think my uni lecturers were trying to tell us. 🙂

tl;dr: Income/Wealth inequality, at extreme levels, can lead to society producing goods and services that only benefit small segments of society. As a result, society’s welfare is not maximised and allocative efficiency is not achieved.

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Till next time, dream economics.

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