Market Failure is NOT...
...when a firm shuts down production. The "Shut Down Price" or an individual firm closing its doors, is not market failure.
Market Failure is...
When a good or service is not produced at the level that would maximize community surplus (community surplus is not maximized).
In other words, a market is said to be in failure when the market is failing to produce the amount of a good or service that society deems to be the optimal amount.
Like other uses of supply and demand, the optimal amount is the quantity where the supply equals the demand. When evaluating markets' success of failure in society, the costs to society and the benefits to society must qual each other. This is what is meant by "maximizing community surplus."
Notice the following graph:
In this graph, the first producer
would be satisfied producing
cigars at a lower price than
the price the equilibrium price.
The second producers would
not produce at as low of a price
as the first but is still willing to product a price lower than equilibrium. The third producer is willing to produce at the equilibrium price. Thus, the first two producers are getting more than the price they are willing to produce cigars. Therefore, the producers are receiving a surplus of satisfaction up to the equilibrium quantity. The blue shaded are is known as producer surplus.
Similarly, in the following diagram, the consumer surplus is illustrated.
The first and second consumer are willing and able to demand cigars
at a price greater than 'P.' They are receiving a surplus of satisfaction
from the cigars. This is why the shaded area on this graph is called
When we think about the cost to society, we think of the consumers and the producers together. Therefore, the consumer surplus, and the producer surplus combine to form the community surplus.
Instead of thinking in terms of supply and demand, we can think in terms of the extra benefit society gets from having more of the good and the extra costs to society of having more of the good. Benefits include the jobs of the people working in the cigar industry, the use of natural resources such as land, and the satisfaction of those who have the freedom to choose to utilize the cigars. The costs include the fact that the land being used to grow tobacco cannot be used to grow something else, say corn. The money spent on cigars cannot be spent somewhere else, say apples.
Society has certain values that determine the extra, or marginal benefit to society and the marginal cost to society. This can be illustrated by changing Supply to "Marginal Social Cost" and Demand to "Marginal Social Benefit."
The quantity marked "Q*" is the quantity where community surplus maximized.
Another way of saying this is to say that the market is operating at "pareto optimality."
This means that for the producers to do any better the consumer would have to do worse. and for the consumers to do any better (get any additional satisfaction) the producers would have to get worse (get less satisfaction).
Markets not in market failure
(producing and consuming the "optimal" amount)
Why markets are in failure
(Why they are not producing at the socially optimal level.)
If, in the above graph, the optimal quantity is at Q*, then an amount less than Q* would be under the optimal level, and an amount greater than Q* would be over the optimal level.
Regarding being over the optimal amount, a good may be either over-produced or over consumed.
Likewise, when discussing the under-optimal quantity, goods may be under-consumed or over consumed.