Market Failure
Market Failure = when markets lead to an inefficient allocation of
resources.
Causes of Market Failure
Public goods
Externalities
Merit and demerit goods
Market imperfections (imperfect information / immobility of factors /
monopoly power)
Public Goods
Private goods = consumption by one person mean that it is not available
for somebody else to consume.
Most goods are private goods.
Characteristics of a public good:
Non-rivalry = consumption does not stop others being able to
consume.
Non-excludability = once provided you cannot stop people
consuming the good.
Market failure occurs with public goods because of the Free Rider Problem:
Because goods are non-excludable, there is an incentive not to pay,
therefore the market will not be able to make a profit, therefore
public goods would not be provided by the market.
This is market failure as the market is not allocating resources to
meet society’s needs.
Public goods are an example of a missing market, known as
complete market failure.
The government provides and everyone pays through taxation.
Therefore, the Free Rider Problem = it is impossible to stop people
benefitting from public goods so there is an incentive to pay for the
good.
,Quasi-Public Goods
Quasi-public good = a good that exhibits some degree of non-rivalry / non-
excludability.
Some goods are not pure public goods:
TV – non-rivalry, but you could exclude people by scrambling the
signal.
Roads – non-rivalry, but you could have a toll booth stopping people
going down the road without paying.
As technology changes, the ability to easily charge people reduces the
impact of the Free Rider Problem, so enables the market to provide.
Semi-non-rival = some goods are non-rivalry up to a certain point (e.g.
beaches and roads)
Once they have reached a certain capacity level, the consumption by one
economic agent does reduce the amount available for someone else.
Externalities
Externalities = occur when producing or consuming a good causes an
impact on 3rd parties not directly related to the transaction.
Types of costs:
(Marginal) private costs = costs faced by the factory when
producing.
(Marginal) external costs = costs faced by 3rd party
(Marginal) social costs = private + external costs
Negative Externalities
Social costs > private costs
This is an example of market failure because more resources will be
allocated to the production of chemicals than there would be if all social
costs had been paid
E.g. pollution
The market is allocating too many resources into one sector which is
harming another and third parties.
, Positive Externalities
Social costs < private costs
Education brings benefits to those who receive it (e.g. better pay), but
society also benefits due to new inventions that an educated society
creates.
However, if all education was left to the market, all schools would be
private and not everyone would be able to go.
This is market failure and why some education is free, and state provided
in the UK.
Marginal private benefits = benefits to the individuals
Marginal external benefits = benefits to a 3rd party.
Marginal social benefits = private + external benefits
Production and Consumption
Externalities can be caused by production or consumption:
Positive consumption (MSB>MPB) – vaccines, education
Negative consumption (MPB>MSB) – gambling, smoking
Positive production (MPC>MSC) – solar panels, new roads
Negative production (MSC>MPC) – pollution, climate change
Negative externalities are associated with other production or
consumption
Positive externalities are associated with under consumption or production
Both represent market failure.
The market will always produce / consumer where MPC = MPB (Q1)
Society will want to produce / consume where MSC = MSB (QE)
Costs / benefits Negative Externality in Production
MSC
(£) MPC Q1 = market output
P2
Qe = socially optimum level
P1
MPB =
Output = Deadweight loss = all external
Qe Q1 (Q) costs. vertical line of triangle =
external cost of Q1
, This is market failure as there is overproduction of goods shown by Q1 and
Qe.
The triangle represents the deadweight loss to society which is all the
external costs.
The triangle always points to the socially optimum level.
Costs / benefits Negative Externality in Consumption
(£) MPC =
P1
P2 MPB
MSB
Output
Qe Q1 (Q)
Costs / benefits Positive Externality in Production
(£) MPC
MSC
P1
P
MPB =
Output
Q1 Qe (Q)
Costs / benefits Positive Externality in Consumption
(£) MPC =
P2
P1 MSB
MPB
Output
Q1 Qe (Q)
Externality Essay Plan
Negative externality in production = MSC > MPC
The market will produce at Q1 which represents a welfare loss to
society as shown by the DWL triangle.
Firms do no consider the impact on 3rd parties, such as the cost of
clearing up the river.
The burden of welfare loss is borne by the taxpayer and local
councils to clean up.
Market Failure = when markets lead to an inefficient allocation of
resources.
Causes of Market Failure
Public goods
Externalities
Merit and demerit goods
Market imperfections (imperfect information / immobility of factors /
monopoly power)
Public Goods
Private goods = consumption by one person mean that it is not available
for somebody else to consume.
Most goods are private goods.
Characteristics of a public good:
Non-rivalry = consumption does not stop others being able to
consume.
Non-excludability = once provided you cannot stop people
consuming the good.
Market failure occurs with public goods because of the Free Rider Problem:
Because goods are non-excludable, there is an incentive not to pay,
therefore the market will not be able to make a profit, therefore
public goods would not be provided by the market.
This is market failure as the market is not allocating resources to
meet society’s needs.
Public goods are an example of a missing market, known as
complete market failure.
The government provides and everyone pays through taxation.
Therefore, the Free Rider Problem = it is impossible to stop people
benefitting from public goods so there is an incentive to pay for the
good.
,Quasi-Public Goods
Quasi-public good = a good that exhibits some degree of non-rivalry / non-
excludability.
Some goods are not pure public goods:
TV – non-rivalry, but you could exclude people by scrambling the
signal.
Roads – non-rivalry, but you could have a toll booth stopping people
going down the road without paying.
As technology changes, the ability to easily charge people reduces the
impact of the Free Rider Problem, so enables the market to provide.
Semi-non-rival = some goods are non-rivalry up to a certain point (e.g.
beaches and roads)
Once they have reached a certain capacity level, the consumption by one
economic agent does reduce the amount available for someone else.
Externalities
Externalities = occur when producing or consuming a good causes an
impact on 3rd parties not directly related to the transaction.
Types of costs:
(Marginal) private costs = costs faced by the factory when
producing.
(Marginal) external costs = costs faced by 3rd party
(Marginal) social costs = private + external costs
Negative Externalities
Social costs > private costs
This is an example of market failure because more resources will be
allocated to the production of chemicals than there would be if all social
costs had been paid
E.g. pollution
The market is allocating too many resources into one sector which is
harming another and third parties.
, Positive Externalities
Social costs < private costs
Education brings benefits to those who receive it (e.g. better pay), but
society also benefits due to new inventions that an educated society
creates.
However, if all education was left to the market, all schools would be
private and not everyone would be able to go.
This is market failure and why some education is free, and state provided
in the UK.
Marginal private benefits = benefits to the individuals
Marginal external benefits = benefits to a 3rd party.
Marginal social benefits = private + external benefits
Production and Consumption
Externalities can be caused by production or consumption:
Positive consumption (MSB>MPB) – vaccines, education
Negative consumption (MPB>MSB) – gambling, smoking
Positive production (MPC>MSC) – solar panels, new roads
Negative production (MSC>MPC) – pollution, climate change
Negative externalities are associated with other production or
consumption
Positive externalities are associated with under consumption or production
Both represent market failure.
The market will always produce / consumer where MPC = MPB (Q1)
Society will want to produce / consume where MSC = MSB (QE)
Costs / benefits Negative Externality in Production
MSC
(£) MPC Q1 = market output
P2
Qe = socially optimum level
P1
MPB =
Output = Deadweight loss = all external
Qe Q1 (Q) costs. vertical line of triangle =
external cost of Q1
, This is market failure as there is overproduction of goods shown by Q1 and
Qe.
The triangle represents the deadweight loss to society which is all the
external costs.
The triangle always points to the socially optimum level.
Costs / benefits Negative Externality in Consumption
(£) MPC =
P1
P2 MPB
MSB
Output
Qe Q1 (Q)
Costs / benefits Positive Externality in Production
(£) MPC
MSC
P1
P
MPB =
Output
Q1 Qe (Q)
Costs / benefits Positive Externality in Consumption
(£) MPC =
P2
P1 MSB
MPB
Output
Q1 Qe (Q)
Externality Essay Plan
Negative externality in production = MSC > MPC
The market will produce at Q1 which represents a welfare loss to
society as shown by the DWL triangle.
Firms do no consider the impact on 3rd parties, such as the cost of
clearing up the river.
The burden of welfare loss is borne by the taxpayer and local
councils to clean up.
