Market failure occurs when the free operation of the market leads to a misallocation of resources, so resources are not allocated in the way that maximises society’s welfare.
In other words:
→ The market produces too much, too little, or none of certain goods and services.
→ The market outcome does not reflect the full costs and benefits to society.
→ As a result, there is a loss of economic welfare.
How Market Failure Occurs
Market forces → market outcome → resources misallocated → social welfare is not maximised
Market failure can arise because:
→ Some goods provide benefits to others that are not reflected in market prices.
→ Some goods impose costs on others that are not reflected in market prices.
→ Consumers may consume too much or too little of certain goods.
→ Private firms may not provide goods that people cannot easily be charged for.
→ A monopoly may restrict output and charge higher prices.
Terms Associated with Market Failure
Public Goods
Public goods are goods that are non-excludable and non-rivalrous.
→ Non-excludable → it is difficult to prevent people from using the good even if they have not paid.
→ Non-rivalrous → one person’s use does not significantly reduce the amount available for others.
Examples:
→ National defence
→ Street lighting
→ Some forms of flood protection
Why public goods can cause market failure
→ People can benefit without paying.
→ This creates a free-rider problem.
→ Private firms may therefore have little incentive to provide the good.
→ The result may be under-provision or non-provision.
Merit Goods
Merit goods are goods or services that are considered to be beneficial to consumers and society, but may be under-consumed if left entirely to the market.
Examples:
→ Education
→ Healthcare
→ Vaccinations
Why merit goods can cause market failure
→ Consumers may underestimate their long-term benefits.
→ Consumers may have imperfect information about the benefits.
→ Some benefits are received by other members of society.
→ Therefore, consumption may be lower than the socially desirable level.
Demerit Goods
Demerit goods are goods or services that are considered to be harmful to consumers and/or society, but may be over-consumed if left entirely to the market.
Examples:
→ Cigarettes
→ Alcohol
→ Some recreational drugs
Why demerit goods can cause market failure
→ Consumers may underestimate the harmful effects.
→ Consumers may have imperfect information.
→ Addiction can make it difficult for consumers to make rational decisions.
→ Some consumption may impose costs on other people.
Benefits
Private Benefits
Private benefits are the benefits received directly by the consumer or producer involved in an economic activity.
Example:
→ A student receives education.
→ The student gains knowledge and qualifications.
→ These are private benefits to the student.
External Benefits
External benefits are benefits received by third parties who are not directly involved in the consumption or production of a good or service.
Example:
→ One person receives a vaccination.
→ The vaccinated person benefits.
→ Other people may also benefit because the risk of disease transmission is reduced.
→ This benefit to others is an external benefit.
Social Benefits
Social benefits are the total benefits to society from an economic activity.
Social benefit = Private benefit + External benefit
For example:
→ Education provides benefits to the student → private benefit
→ A more educated population may create benefits for other people → external benefit
→ Total benefit to society → social benefit
Costs
Private Costs
Private costs are the costs paid directly by the consumer or producer involved in an economic activity.
Example:
→ A factory pays for labour, raw materials, electricity and machinery.
→ These are private costs to the firm.
External Costs
External costs are costs imposed on third parties who are not directly involved in the economic activity.
Example:
→ A factory produces goods and releases pollution.
→ The factory pays its own production costs.
→ Nearby residents may suffer from poorer air quality.
→ The costs imposed on residents are external costs.
Social Costs
Social costs are the total costs to society resulting from an economic activity.
Social cost = Private cost + External cost
For example:
→ Factory pays wages and raw material costs → private costs
→ Pollution harms nearby residents → external costs
→ Total cost to society → social cost
Monopoly
A monopoly is a market structure in which one firm has a dominant position and significant control over the supply of a good or service.
→ The monopolist faces little or no effective competition.
→ This gives the firm significant market power.
→ It may be able to restrict output and charge a higher price than would occur in a more competitive market.
Why monopoly can cause market failure
Market power → output restricted → price higher → consumers buy less → resources misallocated
→ The firm may produce less than the socially efficient level.
→ Some consumers who value the product may be unable or unwilling to buy it at the higher price.
Causes of Market Failure
Public Goods
→ Public goods create a free-rider problem.
→ People can benefit without paying.
→ Private firms may not be able to recover the cost of providing the good.
→ Therefore, the market may provide too little or none of the good.
Example:
→ A private company may find it difficult to charge every person who benefits from national defence.
→ Therefore, the government usually provides it.
Merit Goods
→ Consumers may have imperfect information about the benefits.
→ They may underestimate the long-term benefits.
→ They may therefore consume less than is socially desirable.
Example:
→ A person may choose not to receive a vaccination because they underestimate its benefits.
→ This can result in under-consumption.
Demerit Goods
→ Consumers may have imperfect information about harmful effects.
→ They may underestimate the future costs to themselves.
→ Addiction may make consumption difficult to control.
→ Consumption may therefore be higher than the socially desirable level.
Example:
→ A consumer may continue smoking despite the long-term health risks.
External Costs
→ Producers or consumers may impose costs on third parties.
→ These costs are not included in the market price.
→ Therefore, consumers and producers may make decisions based on private costs rather than the full social costs.
→ Goods with external costs tend to be over-produced and over-consumed.
Example:
→ A factory does not pay the full cost of pollution.
→ Its private production costs are lower than the social costs.
→ The market price may therefore be too low.
→ Quantity demanded and produced may be too high.
External Benefits
→ An economic activity can create benefits for people who are not directly involved.
→ These external benefits may not be reflected in the market price.
→ Consumers and producers consider mainly their private benefits.
→ The good may therefore be under-produced and under-consumed.
Example:
→ Education benefits the individual.
→ It can also create wider benefits through a more skilled and productive population.
→ If these external benefits are ignored, education may be under-consumed.
Abuse of Monopoly Power
→ A monopoly has significant market power.
→ It may restrict the quantity supplied.
→ Reduced supply can allow the firm to charge a higher price.
→ Higher prices reduce consumption.
→ Some consumers who would benefit from the product may no longer be able to afford it.
→ Resources are therefore not allocated efficiently.
Consequences of Market Failure
Market failure means that resources are misallocated.
This can lead to:
→ too many resources being allocated to harmful goods
→ too few resources being allocated to beneficial goods
→ goods not being provided at all
→ higher prices and restricted output under monopoly.
Over-consumption of Demerit Goods
Demerit goods → consumers underestimate harm → consumption too high → excessive resources allocated to production
Examples:
→ cigarettes
→ alcohol
→ unhealthy products
Consequences
→ Poor health may increase.
→ Healthcare costs may increase.
→ Productivity may fall if illness affects workers.
→ Resources are allocated towards producing more of the harmful good than is socially desirable.
Over-consumption of Goods with External Costs
External costs → market price ignores costs imposed on others → price too low → consumption and production too high
Example:
→ A factory produces a polluting product.
→ Consumers consider the price they pay.
→ They do not directly pay the full environmental cost.
→ The product may be over-consumed.
Consequences
→ Pollution increases.
→ Environmental damage occurs.
→ Health problems may increase.
→ Society bears costs that are not reflected in the market price.
Under-consumption of Merit Goods
Merit goods → consumers underestimate benefits → consumption too low → resources allocated away from socially beneficial activities
Example:
→ A person may choose not to undertake education because they focus on the immediate cost.
→ They may underestimate future benefits such as higher income and better employment opportunities.
Consequences
→ Human capital may be lower than its potential.
→ Labour productivity may be lower.
→ Economic growth may be reduced.
→ Society may lose wider benefits from a more educated population.
Under-consumption of Goods with External Benefits
External benefits → benefits to third parties ignored by market decisions → market demand too low → production and consumption too low
Example:
→ Education benefits the student.
→ It can also benefit employers and society through a more skilled workforce.
→ If consumers consider mainly their private benefits, education may be under-consumed.
Consequences
→ Resources are not allocated sufficiently towards activities that benefit society.
→ Potential social benefits are lost.
Non-provision of Public Goods
Public goods → free-rider problem → private firms cannot easily charge users → insufficient incentive to provide → non-provision or under-provision
Example:
→ National defence protects everyone.
→ It is difficult to exclude non-payers.
→ A private firm may therefore have little incentive to provide it.
Consequence
→ An essential good may not be provided by the market.
→ Government provision may be necessary.
Restricted Supply Under a Monopoly
Monopoly power → output restricted → supply reduced → price rises → consumption falls
Consequences
→ Consumers pay higher prices.
→ Some consumers cannot afford the product.
→ Quantity consumed is lower than the socially efficient level.
→ Consumer choice may be reduced.
→ Resources are not allocated efficiently.
→ The monopoly may earn higher profits because of its market power.
Summary of Market Failure
| Cause | Market outcome | Resource misallocation |
|---|---|---|
| Demerit goods | Over-consumption | Too many resources allocated to harmful goods |
| External costs | Over-production/consumption | Too many resources allocated to activities imposing costs on society |
| Merit goods | Under-consumption | Too few resources allocated to beneficial goods |
| External benefits | Under-production/consumption | Too few resources allocated to activities benefiting society |
| Public goods | Under-provision/non-provision | Resources not allocated to goods that society needs |
| Monopoly power | Restricted output + higher prices | Too few resources allocated to the product |
The Core Idea
Market failure = market forces alone do not allocate resources efficiently
→ External costs / demerit goods → too much consumption
→ External benefits / merit goods → too little consumption
→ Public goods → too little or no provision
→ Monopoly power → restricted supply + higher prices
→ Final result → misallocation of scarce resources → society’s welfare is not maximised