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Market Failure
AS Economics
Market Failure – a definition
• Market failure occurs when the free market,
left alone, fails to deliver an efficient
allocation of resources. The result is a loss of
economic and social welfare.
Causes of market failure
• Negative externalities e.g. pollution causing the social cost
to exceed the private costs
• Positive externalities e.g. education causing the social
benefit to exceed the private benefits
• Imperfect information meaning merit goods are underproduced and demerit goods are over-produced
• The private sector being unable to supply important public
and quasi-public goods
• Market dominance by monopolies
• Immobility of factors of production causes unemployment
and productive inefficiency
• Equity (fairness) issues resulting in an unacceptable
distribution of income and social exclusion
Activity 1
Which of the following would provide evidence
of market failure?
a)shortages
b)unemployment
c) unfilled job vacancies
d)output occurring inside the PPF
Market failure and economic efficiency
• MF results in productive inefficiency
• Firms are not maximising output from given
factor inputs
• This is problematic as lost output could have
been used to satisfy more needs and wants;
resources are misallocated and producing
goods and services not wanted by consumers
– resources could have been put to better use
Externalities
• Externalities are costs OR benefits that spill
over to third parties external to a market
transaction
Externalities
Social
costs or
benefits
Private
Costs
or
Benefits
Externality
– positive
or negative
depending
on costs or
benefits
Activity 3
A public house is permitted to stay open all
weekend over the May bank holiday. Identify
one group of people not directly involved in
running or visiting the pub who may:
a)benefit from this decision
b)suffer as a result of this decision
Negative externalities
• Private costs of any action are those suffered by the
individual decision maker
• Social costs of any action are all the conceivable costs
associated with that action
• If social costs exceed private costs then a negative
externality exists; the private optimum level of output
is greater than the social optimum level of output – the
individual or consumer does not take into account the
effects of externalities into their calculations
• PC/SC are usually referred to in the ‘margin’ – the costs
or benefits of one extra unit of output
• So, MSC = MPC + MEC
Positive externalities
• These arise when third parties benefit from
the ‘spillover’ effects of production and
consumption
• Education – improves skills and productivity –
PB of better for employers – earn more – SB –
you increase living standards of the nation
• So, MSB = MPB + MEB
Activity 4
Identify:
a)three private costs a bus company may incur
when operating a bus rout
b)two private benefits a newspaper company
can gain from selling its newspapers
Activity 5
• Identify a benefit the other residents of a
street could gain from one household holding
a firework party to which they were not
invited
Activity 6
• Identify three negative externalities which
villagers may experience as a result of a
bypass being built through their village
Negative externality
S1 (MSC = MPC + MEC)
S (MPC)
price
P1
P
D
0
Q1
Q
Quantity
•At price P and
demand/supply Q, only the
private costs are taken into
account
•If the external costs are
taken into account then the
supply curve would shift to
the left to S1
•Price would rise from P to
P1
•Equilibrium quantity
would fall from Q to Q1
•The negative externality is
causing over-production of
Q-Q1 and the price paid is
lower than it should be
Positive externality
S (MPB)
price
P1
P
•At price P and demand/supply Q, only
the private benefits are taken into
account
•If the external benefits are taken into
account then the demand curve would
shift to the right to D1
•The market equilibrium would be at
Price P1 and Quantity Q1
• When the market fails to operate in this
way there is under-production and this is
shown by the difference between Q1 and
Q
•Too few scarce resources are being used
hence the market failure
D1 (MSB = MPB + MEB)
D (MPB)
0
Q
Q1
Quantity
Recap
•
•
•
•
Negative externalities lead to over-production
Positive externalities lead to under-production
MSC = MPC + MEC
MSB = MPB + MEB
Cheap food – at a huge price &
questions
P91 - 92
Merit and Demerit goods
• Merit goods are more beneficial for consumers
than they realise – usually have positive
externalities. Governments usually subsidise
these so consumption does not depend on ability
to pay
• Left to market forces merit goods would be
under-consumed and so under-produced
(underprovided)
• Demerit goods are more harmful for consumers
than they realise – usually have negative
externalities, and are over-provided
Activity 9
Decide whether the following are merit or demerit goods:
a) heroin
b) catalytic convertors
c) insurance
d) MOT tests
e) public libraries
f) education
g) legal drugs
h) healthcare
i) tobacco
j) vaccinations
k) alcohol
Under-provision of a merit good
S (MSC)
price
P1
P
•Demand (D) is based on an
underestimate of the private
benefits of a merit good.
•The full benefit to consumers
and third parties is represented
by the curve D1
•Society would gain from
increasing output from Q to Q1
D1 (MSB = MPB + MEB)
D (MPB)
0
Q
Q1
Quantity
Over-provision of a demerit good
S (MSC)
price
P
P1
D
•Demand (D) is based on an
overestimate of the private
benefits of a demerit good.
•The full benefit to consumers
and third parties is represented
by the curve D1
•A reduction in output from Q
to Q1 would be a move towards
a more efficient allocation of
resources
D1
0
Q1
Q
Quantity