<p>In this context 'market' usually means some allocation mechanism. For example free market, or a market where someone has monopoly power. Allocation of goods and resources can be done in other ways: e.g. you can divide all resources evenly among production processes and all goods evenly between consumers. This will generally result in allocative inefficiency (were all production processes equally important and efficient?). But it is not market failure because there was no market, just an allocator/social planner.</p>

CC BY-SA 3.0
2016-08-04T07:43:06.013Z
2016-08-04T07:43:06.013Z
Giskard
<p>They are not the same, as others have said. Allocative inefficiency is much more simple - its the amount of efficiency below the optimal allocation. Market failure is not simply inefficiency, but is a systemic inefficiency that won't be naturally improved over time via the actions of self-interested actors.</p>
<p>The <a href="https://governology.substack.com/p/the-role-of-government-part-1" rel="nofollow noreferrer">3 types of market failures</a> are:</p>
<ol>
<li>Externalities</li>
<li>Anti-competitive markets</li>
<li>Suboptimal initial resource allocation</li>
</ol>
<p>All three are situations where the optimal solution resides outside of the pareto frontier.</p>

CC BY-SA 4.0
2023-08-31T03:49:58.277Z
2023-08-31T03:49:58.277Z
B T
<p>Allocative inefficiency refers to a situation where good G was bought by buyer B1 ("allocated" to buyer B1) where it would have been more "efficient" if it had been bought by a different buyer B2 ("allocated" to B2 instead of B1). Good G could be producer goods like oil, lumber, plant equipment, or even consumer goods like sandwiches.</p>

<p>In a free market, the only way buyer B1 gets to bid a good G away from buyer B2 is if B1 voluntarily pays more for G than B2 is willing to pay. This means that in a free market G is always allocated "efficiently", because it goes to the highest bidder, ie the bidder who is obtaining the highest "utility" from G at that point in time (that's why he bid highest). In other words, in a free market, goods are always allocated efficiently.</p>

<p>A good G <em>can</em> be allocated inefficiently to B2 instead of B1 if the market is actively <em>prevented</em> by an external force from allowing B1 to bid G away from B2. There are many ways that this happens today:</p>

<ul>
<li><p>For example, B2 may be subsidized to buy G, which means money is forcibly taken from some tax payers and given to B2, thereby enhancing B2's ability to bid some units of G away from B1. An example of this is when a solar panel manufacturer is subsidized, thereby enhancing his ability to bid away goods from other manufacturers via this mechanism. The subsidy has forcibly disrupted the market and caused allocative inefficiency, as compared to the efficient allocation that would have been provided by the free market.</p></li>
<li><p>As another example, the regulatory burden imposed on B1 may be higher than that imposed on B2, causing B1 to bleed resources away thereby reducing its ability to bid some units of G away from B2. Say a mom &amp; pop restaurant B1 is forced to comply with a newly imposed food safety regulation, and they spend a higher percentage of their revenue on compliance than would a chain restaurant competitor B2 who already has a compliance department and therefore incurs smaller marginal cost of compliance. In this case, mom &amp; pop restaurant B1 bleeds more compliance cost than chain competitor B2, reducing mom &amp; pop B1's ability to bid goods G away from chain B2. In the free market some units of good G would go to B1, but after forcible imposition of the additional regulatory compliance some of those units instead go to B2. The regulatory burden has disrupted the free market and caused allocative inefficiency compared to the efficient allocation that would have taken place in the free market.</p></li>
</ul>

<p>This is why the phrase "market failure" is misleading and incorrect. The free market allocates efficiently, because goods go to the highest bidder. It is "forced market disturbance" that causes allocative inefficiency by disrupting the free market. Therefore, more forced market disturbance means less efficientcy, and less forced market disturbance means more efficiency, with maximum allocative efficiency when the market is free of all forced market disturbances (taxes, regulation, subsidies, red tape, etc.)</p>

CC BY-SA 3.0
2016-08-04T21:27:57.723Z
Your last paragraph seems a little dogmatic. What about adverse selection and efficient levels of public goods? Is there no market failure in these cases?
Giskard
CC BY-SA 3.0
2016-08-04T23:32:35.970Z
Thank you for commenting.  "Adverse selection" means one side of the transaction has information that the other side does not have, eg selling a car without disclosing some hidden damage. It is a risk the buyer willingly takes in exchange for a perceived value that compensates for the risk, for example the car is cheaper than buying it new at a dealer. There is no inefficient allocation or market failure.    A "public good" is something like freeways or parks, but since they are not a product of the free market, their deficiencies cannot be attributed to any "market failure".
user269602
CC BY-SA 3.0
2016-08-05T08:27:56.837Z
Thank you for your answer. I know what adverse selection is. It can result in inefficient allocation. I recommend reading Akerlof's ["Market for lemons"](http://www.iei.liu.se/nek/730g83/artiklar/1.328833/AkerlofMarketforLemons.pdf) article. He provides an example where asymmetric information results in utility loss on pg. 492.
Giskard
CC BY-SA 3.0
2016-08-05T17:06:02.920Z
Certainly - I merely provided a quick description of "adverse selection" for readers unfamiliar w the term. Specifically, Akerlof's nice article describes that under info asymmetry, eg a car seller selling a lemon w/o disclosure, the effect is a feedback loop-like drop in avg quality of used cars for sale as lemons drive out good used cars, bec sellers increasingly withhold good used cars as avg prices decline (like Gresham's law). So far so good. But that is not "market failure". Akerlof himself lists various market solutions eg warranties, brand names, certification, etc. (Section IV pg 499)
user269602
CC BY-SA 3.0
2016-08-05T18:02:28.550Z
Yes, there are possible solutions, but this not what you wrote in your comment. "It is a risk the buyer willingly takes in exchange for a perceived value that compensates for the risk, for example the car is cheaper than buying it new at a dealer. There is no inefficient allocation or market failure." Certainly the original market, the one without the possible solutions you list fails? And in your answer you list "regulation" and "red tape" as "forced market disturbance". But then you list certification as a good thing in your comment. Clarify?
Giskard
CC BY-SA 3.0
2016-08-05T23:03:40.557Z
On the contrary, what you call "failure" is precisely the "efficient allocation" function of the free market. The "original market" is the used car market at a time when lemons are sold but solutions (eg warranties) are not offered by entrepreneurs. This is because the scarce resources required for such solutions are being *more efficiently* allocated to other more urgent competing needs in society. If and when the lemon problem gets urgent enough, entrepreneurs will bid resources away from less urgent competing needs and offer "lemon" solutions. This is efficient allocation, not failure.
user269602
CC BY-SA 3.0
2016-08-05T23:10:30.027Z
Thanks for pointing that out. Regarding "certification", I of course mean market provided voluntary certifications, such as Carfax, or "Cisco Certified Network Associate", etc.  I do not mean certification requirements forcibly imposed by regulators, since those disturb voluntary exchange and hinder the free market's function of efficient allocation.
user269602
CC BY-SA 3.0
2016-08-05T23:52:20.817Z
"This is because the scarce resources required for such solutions are being more efficiently allocated to other more urgent competing needs in society." Please show where this is stated in the Akerlof paper.
Giskard
CC BY-SA 3.0
2016-08-05T23:53:13.143Z
You seem to assume some things that are not there when it is convenient for your point of view. I am sorry but to me this seems to be a fanatical libertarianism. Everything that is regulation is wrong. The free market is always right, and even when it is wrong, it is wrong because it is right!
Giskard
CC BY-SA 3.0
2016-08-08T16:38:35.753Z
Please point out the alleged "convenient" assumptions in my logic. Also, what you quoted two comments ago were my words, not Akerlof's, else I would have enclosed them in quotes and provided the reference.
user269602
CC BY-SA 3.0
2016-08-08T18:19:49.220Z
Yes, I suspected it does not appear in the Akerlof paper. Without any proof to back up the quoted part, it is a convenient assumption.
Giskard
CC BY-SA 3.0
2016-08-08T18:50:04.693Z
The resources are clearly being allocated elsewhere, so the only question is whether that "allocation elsewhere" is indeed "more efficient" than say regulating the used car market. My position is that it is indeed more efficient because they went to the highest bidders. How else would you judge whether one allocation is more efficient than another? This is a genuine question and any pointers would be appreciated. Thank you.
user269602
CC BY-SA 3.0
2016-08-08T19:01:07.773Z
There are several ways. Akerlof calculated if the allocation is Pareto-optimal, e.g. if you can increase improve someone's utility without loss to others. You can also calculate which allocation results in greatest consumer's surplus + producer's surplus.
Giskard
CC BY-SA 3.0
2016-08-04T19:21:02.967Z
2016-08-04T23:09:46.470Z
2016-08-04T23:09:46.470Z
user269602
<p>From an IB Economics book (in the microeconomics section):</p>

<hr>

<p><a href="https://i.sstatic.net/kcEI1.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/kcEI1.png" alt="enter image description here"></a></p>

<hr>

<p>The part in blue suggests market failure is the same as allocative inefficiency, but the part in red seems to suggest that market failure is one cause or type of allocative inefficiency.</p>

<p>What is the difference between the two, if any?</p>

<microeconomics><efficient-markets><economic-failure><market-failure>
Is market failure the same allocative inefficiency?
BCLC
# Is market failure the same allocative inefficiency?

(Asked by: username_0 on 2016-08-04)

From an IB Economics book (in the microeconomics section):

---

[![enter image description here](https://i.sstatic.net/kcEI1.png)](https://i.sstatic.net/kcEI1.png)

---

The part in blue suggests market failure is the same as allocative inefficiency, but the part in red seems to suggest that market failure is one cause or type of allocative inefficiency.

What is the difference between the two, if any?

**Tags:** microeconomics, efficient-markets, economic-failure, market-failure

---

## 3 answers

### Answer by username_1 on 2016-08-04. Score: 2

In this context 'market' usually means some allocation mechanism. For example free market, or a market where someone has monopoly power. Allocation of goods and resources can be done in other ways: e.g. you can divide all resources evenly among production processes and all goods evenly between consumers. This will generally result in allocative inefficiency (were all production processes equally important and efficient?). But it is not market failure because there was no market, just an allocator/social planner.


---

### Answer by username_2 on 2023-08-31. Score: 0

They are not the same, as others have said. Allocative inefficiency is much more simple - its the amount of efficiency below the optimal allocation. Market failure is not simply inefficiency, but is a systemic inefficiency that won't be naturally improved over time via the actions of self-interested actors.

The [3 types of market failures](https://governology.substack.com/p/the-role-of-government-part-1) are:

1. Externalities
2. Anti-competitive markets
3. Suboptimal initial resource allocation

All three are situations where the optimal solution resides outside of the pareto frontier.


---

### Answer by username_3 on 2016-08-04. Score: 0

Allocative inefficiency refers to a situation where good G was bought by buyer B1 ("allocated" to buyer B1) where it would have been more "efficient" if it had been bought by a different buyer B2 ("allocated" to B2 instead of B1). Good G could be producer goods like oil, lumber, plant equipment, or even consumer goods like sandwiches.

In a free market, the only way buyer B1 gets to bid a good G away from buyer B2 is if B1 voluntarily pays more for G than B2 is willing to pay. This means that in a free market G is always allocated "efficiently", because it goes to the highest bidder, ie the bidder who is obtaining the highest "utility" from G at that point in time (that's why he bid highest). In other words, in a free market, goods are always allocated efficiently.

A good G *can* be allocated inefficiently to B2 instead of B1 if the market is actively *prevented* by an external force from allowing B1 to bid G away from B2. There are many ways that this happens today:

* For example, B2 may be subsidized to buy G, which means money is forcibly taken from some tax payers and given to B2, thereby enhancing B2's ability to bid some units of G away from B1. An example of this is when a solar panel manufacturer is subsidized, thereby enhancing his ability to bid away goods from other manufacturers via this mechanism. The subsidy has forcibly disrupted the market and caused allocative inefficiency, as compared to the efficient allocation that would have been provided by the free market.
* As another example, the regulatory burden imposed on B1 may be higher than that imposed on B2, causing B1 to bleed resources away thereby reducing its ability to bid some units of G away from B2. Say a mom & pop restaurant B1 is forced to comply with a newly imposed food safety regulation, and they spend a higher percentage of their revenue on compliance than would a chain restaurant competitor B2 who already has a compliance department and therefore incurs smaller marginal cost of compliance. In this case, mom & pop restaurant B1 bleeds more compliance cost than chain competitor B2, reducing mom & pop B1's ability to bid goods G away from chain B2. In the free market some units of good G would go to B1, but after forcible imposition of the additional regulatory compliance some of those units instead go to B2. The regulatory burden has disrupted the free market and caused allocative inefficiency compared to the efficient allocation that would have taken place in the free market.

This is why the phrase "market failure" is misleading and incorrect. The free market allocates efficiently, because goods go to the highest bidder. It is "forced market disturbance" that causes allocative inefficiency by disrupting the free market. Therefore, more forced market disturbance means less efficientcy, and less forced market disturbance means more efficiency, with maximum allocative efficiency when the market is free of all forced market disturbances (taxes, regulation, subsidies, red tape, etc.)

> **Comments:**
> **username_1**: Your last paragraph seems a little dogmatic. What about adverse selection and efficient levels of public goods? Is there no market failure in these cases?  
> **username_3**: Thank you for commenting.  "Adverse selection" means one side of the transaction has information that the other side does not have, eg selling a car without disclosing some hidden damage. It is a risk the buyer willingly takes in exchange for a perceived value that compensates for the risk, for example the car is cheaper than buying it new at a dealer. There is no inefficient allocation or market failure.    A "public good" is something like freeways or parks, but since they are not a product of the free market, their deficiencies cannot be attributed to any "market failure".  
> **username_1**: Thank you for your answer. I know what adverse selection is. It can result in inefficient allocation. I recommend reading Akerlof's ["Market for lemons"](http://www.iei.liu.se/nek/730g83/artiklar/1.328833/AkerlofMarketforLemons.pdf) article. He provides an example where asymmetric information results in utility loss on pg. 492.  
> **username_3**: Certainly - I merely provided a quick description of "adverse selection" for readers unfamiliar w the term. Specifically, Akerlof's nice article describes that under info asymmetry, eg a car seller selling a lemon w/o disclosure, the effect is a feedback loop-like drop in avg quality of used cars for sale as lemons drive out good used cars, bec sellers increasingly withhold good used cars as avg prices decline (like Gresham's law). So far so good. But that is not "market failure". Akerlof himself lists various market solutions eg warranties, brand names, certification, etc. (Section IV pg 499)  
> **username_1**: Yes, there are possible solutions, but this not what you wrote in your comment. "It is a risk the buyer willingly takes in exchange for a perceived value that compensates for the risk, for example the car is cheaper than buying it new at a dealer. There is no inefficient allocation or market failure." Certainly the original market, the one without the possible solutions you list fails? And in your answer you list "regulation" and "red tape" as "forced market disturbance". But then you list certification as a good thing in your comment. Clarify?  
> **username_3**: On the contrary, what you call "failure" is precisely the "efficient allocation" function of the free market. The "original market" is the used car market at a time when lemons are sold but solutions (eg warranties) are not offered by entrepreneurs. This is because the scarce resources required for such solutions are being *more efficiently* allocated to other more urgent competing needs in society. If and when the lemon problem gets urgent enough, entrepreneurs will bid resources away from less urgent competing needs and offer "lemon" solutions. This is efficient allocation, not failure.  
> **username_3**: Thanks for pointing that out. Regarding "certification", I of course mean market provided voluntary certifications, such as Carfax, or "Cisco Certified Network Associate", etc.  I do not mean certification requirements forcibly imposed by regulators, since those disturb voluntary exchange and hinder the free market's function of efficient allocation.  
> **username_1**: "This is because the scarce resources required for such solutions are being more efficiently allocated to other more urgent competing needs in society." Please show where this is stated in the Akerlof paper.  
> **username_1**: You seem to assume some things that are not there when it is convenient for your point of view. I am sorry but to me this seems to be a fanatical libertarianism. Everything that is regulation is wrong. The free market is always right, and even when it is wrong, it is wrong because it is right!  
> **username_3**: Please point out the alleged "convenient" assumptions in my logic. Also, what you quoted two comments ago were my words, not Akerlof's, else I would have enclosed them in quotes and provided the reference.  
> **username_1**: Yes, I suspected it does not appear in the Akerlof paper. Without any proof to back up the quoted part, it is a convenient assumption.  
> **username_3**: The resources are clearly being allocated elsewhere, so the only question is whether that "allocation elsewhere" is indeed "more efficient" than say regulating the used car market. My position is that it is indeed more efficient because they went to the highest bidders. How else would you judge whether one allocation is more efficient than another? This is a genuine question and any pointers would be appreciated. Thank you.  
> **username_1**: There are several ways. Akerlof calculated if the allocation is Pareto-optimal, e.g. if you can increase improve someone's utility without loss to others. You can also calculate which allocation results in greatest consumer's surplus + producer's surplus.  

---

