Economics 9708/32 — February/March 2016

Background Concept

Market failure is a situation where the allocation of goods and services by a free market is not efficient, meaning there is a net welfare loss to society. One common cause is the absence of well-defined property rights. When property rights are unclear or cannot be enforced, the market cannot price resources correctly, leading to externalities (costs or benefits that affect third parties) and overexploitation of common resources (the tragedy of the commons).

Understanding the Question

This is a multiple-choice question asking for an example of market failure. It tests the ability to distinguish genuine instances of market failure from normal market outcomes or other economic concepts. The options include a clear cause of market failure (difficulties in allocating property rights) and three distractors that are not market failures.

Approach

First, recall the definition of market failure: inefficiency where the market does not achieve allocative efficiency, often due to externalities, public goods, imperfect information, or missing property rights. Then evaluate each option against this definition.

Step-by-Step Reasoning

• Option A: Difficulties in allocating property rights. This is a textbook cause of market failure. Without clear property rights, resources may be overused or under-provided, leading to inefficiency (e.g., oceans, the atmosphere). This fits perfectly.
• Option B: Diseconomies of scale. This refers to a rise in long-run average costs as a firm becomes too large. It is a cost phenomenon and does not in itself cause market failure; in fact, it may be internalised by the firm.
• Option C: High prices caused by increased demand. In a well-functioning market, high prices are a signal of scarcity and serve to allocate resources efficiently. This is a normal market outcome, not a failure.
• Option D: The existence of scarcity. Scarcity is a fundamental economic problem that exists in all societies; it is not a failure of the market but the reason economics exists.

Thus, only option A is a valid example of market failure.

Key Takeaways

• Market failure is about inefficiency, not about high prices or scarcity.
• Property rights are a cornerstone of efficient markets; their absence is a major source of market failure.
• Always test whether a given situation violates the conditions for an efficient market (e.g., externalities, public goods, imperfect competition, missing property rights).

Common Mistakes

• Confusing market failure with normal market adjustments (e.g., price changes due to demand shifts).
• Thinking that scarcity itself is a market failure; scarcity is the reason we need markets.
• Assuming that any negative outcome (like increasing costs) is a market failure, when it may be a natural part of production.

Things to Be Careful About

• Read the question carefully: it asks for an example of market failure, not a definition or a cause. The options require you to recognise which one is a recognised type of market failure.
• Distinguish between market imperfections (like monopoly) which can cause failure, and other economic concepts.
• Remember that property rights issues are a classic example, often linked to externalities and public goods.