5.

Market Failure
Market Failure: occurs when the price mechanism (forces of supply and demand) fail
to allocate resources efficiently. Scarce resources are allocated inefficiently leading
to either over-provision or under-provision.
Examples of market failure:
Under-provision of merit goods such as healthcare, education as these are
services provided to those who are willing and able to pay
Under-provision of public goods such as street lights and public roads, as
producers are unable to exclude those who do not pay for these benefits
Over-provision of demerit goods such as cigarettes and alcohol due to lack of
strict government intervention
Abuse of monopoly power costumers are charged prices of higher than
equilibrium
Market failure occurs when resources are allocated inefficiently, but also cause
external costs or external benefits of production and consumption.
Private benefits benefits of production and consumption enjoyed by a firm,
individual or government
Private costs cost of production and consumption incurred by a firm,
individual or government
Social benefits the sum of private benefits and external benefits
Social costs the sum of private costs and external costs
Externalities: the external costs or benefits of an economic transaction, causing the
market to fail to achieve a social level of output where marginal social benefits
equal social marginal costs (MSB=MSC).
Marginal private benefit (MPB) is the additional value enjoyed by the
consumers and firms from the consumption or production of an extra unit of
good or service.
Marginal private cost (MPC) is the additional cost of production firms or the
extra charge paid by consumers for the output or consumption of an extra
good or service.
External costs (Negative externalities): costs incurred by a third party in an
economic transaction for which no compensation is paid.
e.g: - passive smoking, air pollution from vehicles and factories, child obesity
from fast food and carbonated drinks, litter on public beaches, climate change
External benefits (Positive externalities): benefits gained by a third party from an
economic activity.
e.g: - national defense, police and emergency services, public parks/libraries

Negative externalities of production and consumption

Negative externalities arise from the production or consumption of goods and
services that create negative spillover effects on a third party. These are known as
demerit goods. E.g cigarettes, alcohol, hard drugs.
The government intervenes to discourage the production and consumption of
demerit goods.
Negative externalities of production

In a free market economy, with no

government intervention, output will be
at Qe and Pe, where MPC=MPB of
production.
However, the socially optimum output
is at Q* and P*, where consumption
levels are low and prices are high.
The shaded triangle depicts the welfare
gain of reducing output of demerit
goods.

Negative externalities of consumption

negative externalities).

Policy responses to negative externalities

In a free market economy, output will

be at Qe and Pe, which exceeds the
socially optimum level of Q*
The negative externality accounts for
the difference between the MSB and
MPB.
Hence, there is overconsumption of
demerit goods in the absence of
government intervention
The shaded area shows the welfare loss
of consumption (of products with

Governments try to solve market failure in two mains ways:

Market-based policies: intervention in the price mechanism to make
the market forces of demand supply operate more effectively e.g
taxation and tradable permits
Government regulations: such as environmental standards
Taxation is used to internalise negative externalities. i.e the buyer and /or seller
pay for the true costs of their actions without any burden being placed on third
parties.
Consequences of imposing taxes
Advantages
Increases the price, decreasing
quantity demanded.

Creates tax revenue for the

government which

Disadvantages
Demand for many of these
products tend to be inelastic, the
increase in price doesnt affect the
quantity demanded
It can encourage the starting of
black markets, with smuggling.

Tradable permits are pollution rights issued to a firm, limiting the level of pollution
from economic activity. This policy creates incentives not to pollute so that excess
permits can be sold to other less efficient firms.
Governments also impose regulations and laws to deal with negative
externalities from production and consumption. Such as:
Laws on minimum legal ages to purchase goods such as alcohol and
cigarettes
Laws to make it illegal for people to smoke in certain public areas
Laws on making passengers wear safety belts and motorcyclists, helmets
Laws on regulation night flights at airports to limit noise pollution
Consequences of imposing regulations and laws
Advantages
Consumption of the good or service
may be reduced
Awareness of the negative impacts
of demerit goods might change the
behavior of consumers

Disadvantages

People may still chose to ignore the

laws, causing underground illegal
markets to develop
Government has no control

Positive externalities of production and consumption

Merit goods: products that create positive externalities when they are produced or
consumed. Hence the social benefits from the production and consumption of merit
goods are greater than the private benefits. (e.g healthcare, education,
infrastructure)
Positive externalities of consumption

Positive externalities exist because

MSB>MPB of consumption at all
levels of output.
Market failure is at Pe and Qe, as
there is an under-consumption of
merit goods.
The socially desirable level of output
where MSB=MSC, that is at Q*
Positive externalities of production

The free market fails to supply

goods with positive
externalities at socially
optimum level of output at P*
Q*
There is an under-provision of
goods at Pe and Qe, with less
production and high prices.
Government intervention
increases the output to the
socially optimum level of Q*
P* with more production and
prices.

and

and
lower

Government responses to positive externalities

Subsidies are a sum of money give to producers to reduce the costs of
production, incentivizing higher levels of production, or to consumers to
reduce the price of consumption (e.g subsidise public transport)
o If for example, public transport is subsidized, it will lower traffic
congestion, hence reducing the negative externality caused by driving
private vehicles. However:

If price elasticity of demand is inelastic, low prices will have little

impact on quantity demanded.
The social return on merit goods is difficult to measure as its
subjective
There is an opportunity cost involved as governments can choose
to spend the subsidy money on other projects

Legislation are laws used to encourage greater consumption of goods and

services with positive externalities such as, compulsory education for
children, and the requirement for school children to be vaccinated against
certain diseases.
Advertising is used to influence consumer behavior by also bringing in
awareness, informing and educating the public about the benefits of
consumption of merit goods.
o Schools educating students about safe sex and family planning
o Advertising health screening services such as cholesterol levels,
diabetes, strokes
o Advertising the importance of environment protections, e.g recycling
Consequences of imposing regulations and laws
Advantages
Disadvantages
Behavior and consumption
Not all advertising is effective, it
patterns of consumers and firms
may not change peoples
change
behavior, or it may take a long
period of time for change to occur.
Successful advertising may lead to
There is an opportunity cost of
cultural change in behavior, e.g
government expenditure on
healthy eating, no smoking, waste
advertising.
reduction, recycling.
Direct provision of goods and services is when the government
institutions provide the public with merit goods such as public transportation,
healthcare, education, etc.
o Its an advantage as these public goods become accessible to
everyone, regardless of their income or social status. However:
Economic inefficiency might encourage over consumption, as
people do not have to pay for it.
Incase of a shortage in supply, due to excess demand, it can be
difficult to decide who should be able to take advantage of the
free government service.
o Seen as favorable for the economy as MSB>MSP.
Lack of Public Goods

Public goods: goods and services that exert positive externalities, with two key
characteristics: non-rivalrous and non-excludable. (e.g national defense, emergency
services, street lighting)
Non-rivalrous: a persons consumption of a public good does not limit the
benefits available to others.
Non-excludable: firms cannot exclude people from the benefits of
consumption, even if they do not pay.
Private goods on contrast tend to be rivalrous (e.g cinema>> theatre tickets) and
excludable (e.g airlines, restaurants) and reject-able.
The lack of provision of public goods is another source of market failure. This is due
to the free rider problem where those who do not pay cant be excluded from
benefiting the provision of public goods. Free riders are those who take advantages
of goods/services provided by the government but have not paid/made
contributions to government revenue through taxes.