Market Failure | O Level Economics 2281 & IGCSE Economics 0455 | Detailed Free Notes To Score An A Star (A*)
2.10.1 Definition of Market Failure
- Market failure occurs when the price mechanism fails to allocate resources efficiently, resulting in overproduction or underproduction of certain goods and services.
- In such cases, the market does not achieve allocative efficiency, and social welfare is not maximized.
2.10.2 Causes of Market Failure
Market failure arises from various sources. Below are the main causes relevant to the syllabus:
A. Public Goods
- Definition:
- Goods that are non-excludable (you can’t stop someone from using them) and non-rivalrous (one person’s use doesn’t reduce availability for others).
- Examples: National defense, street lighting.
- Why Market Fails:
- Firms can’t charge users directly → No profit incentive → Underprovided or not provided at all.
- Known as the free rider problem.
B. Merit Goods
- Definition:
- Goods that are under-consumed if left to the market because individuals underestimate their benefits.
- Examples: Education, vaccinations, public libraries.
- Why Market Fails:
- People may not realize long-term benefits.
- Low income may restrict access.
- Leads to under-consumption and underproduction.
- Related Concept:
- External benefits (positive externalities): Benefits to third parties (e.g., educated people benefit society via higher productivity and lower crime).
C. Demerit Goods
- Definition:
- Goods that are over-consumed if left to the market because individuals ignore or underestimate the harms.
- Examples: Cigarettes, alcohol, junk food.
- Why Market Fails:
- Lack of information or addiction.
- Leads to over-consumption and overproduction.
- Related Concept:
- External costs (negative externalities): Harms to third parties (e.g., second-hand smoke, public healthcare burden).
D. Externalities
- Private Costs: Costs borne by the individual producer/consumer.
- External Costs: Costs imposed on third parties (e.g., pollution, noise).
- Social Costs = Private Costs + External Costs
- Private Benefits: Gains to individual consumer/producer.
- External Benefits: Gains to third parties (e.g., herd immunity from vaccines).
- Social Benefits = Private Benefits + External Benefits
- Market failure occurs when:
- External costs are ignored → overproduction
- External benefits are ignored → underproduction
E. Abuse of Monopoly Power
- Definition: A monopolist can set prices above competitive levels, restrict output, and limit consumer choice.
- Why Market Fails:
- Leads to allocative inefficiency, higher prices, and reduced consumer surplus.
- Resources are misallocated away from consumer welfare.
F. Factor Immobility
- Definition: Occurs when resources (especially labor) cannot move easily between jobs or locations.
- Examples:
- Structural unemployment due to outdated skills.
- Geographical immobility due to housing costs or family ties.
- Why Market Fails:
- Leads to underutilized resources.
- Slows economic adjustment and reduces output.
2.10.3 Consequences of Market Failure
| Type of Market Failure | Consequences |
|---|---|
| Public Goods | No private provision → government must intervene. |
| Merit Goods | Under-consumption → long-term harm (e.g., uneducated workforce). |
| Demerit Goods | Over-consumption → negative health, environmental & economic outcomes. |
| External Costs | Pollution, health damage, environmental degradation. |
| External Benefits | Lost opportunities for societal gain. |
| Monopoly Power | Exploitation, reduced innovation, and high prices. |
| Factor Immobility | Long-term unemployment, regional disparities. |
Misallocation of Resources
- Overconsumption of demerit goods:
- Resources shift towards harmful industries.
- Societal harm increases (healthcare costs, productivity loss).
- Underconsumption of merit goods:
- Long-term negative effects on economic growth and social welfare.
- Widening inequality and reduced human capital.
- Market allocates based on private costs/benefits, ignoring the full social cost/benefit, causing misallocation.
Summary of Key Terms
| Term | Definition |
|---|---|
| Public Good | Non-excludable, non-rivalrous goods (e.g., national defense) |
| Merit Good | Under-consumed goods with external benefits (e.g., healthcare) |
| Demerit Good | Over-consumed goods with external costs (e.g., cigarettes) |
| Private Costs | Costs paid by individuals or firms directly involved |
| External Costs | Costs suffered by third parties (e.g., pollution) |
| Social Costs | Total costs = private costs + external costs |
| Private Benefits | Benefits enjoyed by the consumer or producer |
| External Benefits | Benefits to society or third parties |
| Social Benefits | Total benefits = private + external benefits |
Government Role in Correcting Market Failure
- Subsidies for merit goods (e.g., education, healthcare).
- Taxes on demerit goods (e.g., sin tax on alcohol/cigarettes).
- Laws and regulations (e.g., pollution limits, safety standards).
- Provision of public goods directly (e.g., defense, infrastructure).
- Antitrust laws to prevent monopoly abuse.
- Retraining programs to improve labor mobility.
Exam Tip
- Do not draw diagrams—not required for this topic.
- Focus on real-world examples tied to each cause.
- Clearly define each key term (e.g., merit good, external cost).
- Relate misallocation directly to social vs. private cost/benefit divergence.
- Link government solutions to specific types of failure.
