i. Market failure - an overview

In theory, markets produce the goods and services we want in the right quantities and at the lowest possible cost. This is why markets are so powerful. But in the real world markets do not always work in the way theory predicts. It is possible for a free market to produce a Pareto inefficient result - i.e. the market fails.

An information system

A market is an information system. We get the right goods at the lowest possible cost because the market is able to transmit all the information about benefits and costs between producers and consumers (Unit 2. 1. f.) 2If this information is less than perfect, then the market will fail.

Think about buying a CD. You know what a CD is, and you will also have a good idea of the kind of music on the disc.

So you are able to relate your benefit to the price of the CD. If we look at the market for CDs, people will go on buying CDs until the extra satisfaction from the last CD is exactly equivalent to the price of the CD. We have reached the situation where we as a society are consuming the 'right' quantity of CDs in the sense that we are gaining the maximum possible satisfaction from CDs given their price.

Why might markets fail?

But health care is rather different from CDs. We face very acute information problems which make rational purchasing decisions difficult if not impossible. For instance most people do not know the best way to treat a stomach ulcer so they would find it difficult to buy such treatment.

This analysis also assumes that the only people receiving benefit or satisfaction from the CDs are the people buying them. In other words, the price of a CD accurately conveys the level of satisfaction received. This ignores the possibility of externalities or 'spillovers'. Think about someone hearing your CD and enjoying it - they are also receiving satisfaction from the disc but the market is unable to provide any information about the benefits they are receiving unless they specifically share the cost of buying the CD. Whenever externalities occur, the market fails. Many economists believe that there are strong externality effects related to health care. For example caring for a sick person can impose financial costs on that person's family. We discuss externalities more fully in subsection vi of this Unit.

Perfect competition

An efficient free market requires producers to be operating under conditions of perfect competition. This requires a stringent set of conditions - perfect information, many buyers and sellers, a uniform product and freedom of entry and exit - which ensure that firms are price takers, producing for the lowest possible cost in the long run and only earning normal profits.

If producers do not operate in this way and, in particular, if they have a significant power to influence price or the total quantity being produced, then the market will fail. Doctors and other suppliers of health care often have this power.