Grade 9 : Market Failure Chapter Key Definitions : Market failure occurs when the price mechanism and the forces of demand and supply allocate resources in an inefficient way. This means there is either over-production, under-production, over-consumption, or under-consumption of goods or services. It happens when the consumption of a product causes additional positive or negative side effects to those parties who are not involved in the purchase or sale of the product. In other words, the market fails to clear at an equilibrium position. For example, in the absence of government intervention, the following are examples of market failure: - Under-provision and under-consumption of education and healthcare because these services would only be offered to individuals and households who are able and willing to pay, despite the external benefits these have to the economy and society. - Under-provision of street lighting, public roads, and motorways (highways) as private sector firms are unable cannot exclude those who do not pay benefiting from the provision of these services. - Overconsumption of alcohol, cigarettes, and gambling services in a market economy due to the lack of government intervention to regulate the consumption of these products. - Overproduction of products that rely on the extraction and use of non-renewable resources, such as fossil fuels and minerals. Hence, such economic activity can cause irrecoverable damage to the environment. 1. Public goods Public goods are products that are non-excludable and non-rivalrous in consumption. Non-excludable means that individuals and households who are unable or unwilling to pay for a good or service can still enjoy access. Non-rivalrous means one person's purchase or use of a product does not diminish the amount available to others. Grade 9 : Market Failure Chapter In a market economic system, the private sector fails to provide sufficient quantities of certain public goods and services. This is because private sector firms lack the profit motive to supply these products given the characteristics of non-excludability and non-rivalry. Examples of public goods include: Flood control systems Law and order Lighthouses Online search engines National defence 2. Merit goods Merit goods are products that generate benefits to society but are under-provided and under-consumed in a market economic system. Merit goods create positive externalities (or positive spillover effects) to those not directly involved in production or consumption. In other words, the social benefits of production and consumption of merit goods outweigh the private benefits. Examples of merit goods include: Education Fire protection Healthcare services Note that merit goods are provided in both the public and private sectors of the economy. For example, there are state-funded schools as well as private independent schools that provide educational services. People can choose to use private healthcare services or government-funded healthcare provision. Hence, merit goods are under-provided and under-consumed without government intervention or public sector provision of these goods and services. 3. Demerit goods Demerit goods are products that generate negative externalities (spillover costs) to society yet are over-provided and over-consumed in a market economic system. Examples of demerit goods include: Grade 9 : Market Failure Chapter Alcoholic beverages Cigarettes and tobacco 4. Social benefits Social benefits are the full or all-encompassing benefits of production or consumption of a good or service. It is expressed as the sum of private benefits and external benefits of production or consumption of a merit good or public good, i.e., it represents the true economic costs of production or consumption. Social benefit = Private benefits + External benefits For example, when people have a COVID-19 vaccination, they gain the private benefit of reducing the chances of getting ill from the virus. However, there are also external benefits to other people as they are also protected from the COVID-19 coronavirus. If vaccinations were left to the choice of individuals in a market economic system, they would be under-consumed and therefore under-produced, mainly because of the relatively high price of vaccinations. To correct this market failure, many governments provide vaccines free of charge (funded by the government) to incentivise people to have their vaccinations in order to generate greater social benefits. 5. External benefits External benefits are the positive spillover effects (beneficial side effects) of production or consumption enjoyed by those not directly involved in the buying or selling of a particular good or service. For example, the flowers, plants, trees, and wildlife in a public park are beneficial to the natural environment and the wellbeing of local residents and visitors. Other examples of merit goods and public goods with external benefits include education, training, research and development, museums, public parks, law enforcement, and vaccinations. 6. Private benefits Grade 9 : Market Failure Chapter Private benefits of production or consumption refer to the satisfaction or gains from economic activities experienced by individuals, households, firms, or the government. For example, a private motorists can benefit from the convenience of owning their private mode of transport. A student gains the private benefits of a well-rounded education as they are knowledgeable and become more employable. Workers gain private benefits of a good healthcare system as they are healthy and fit for work. 7. Social costs Social costs are the full or all-encompassing expenses of production or consumption of a good or service. It is expressed as the sum of private costs and external costs of production or consumption of a demerit good or any good that has negative externalities, i.e., it represents the true economic costs of production or consumption. Social costs = Private costs + External costs For example, food production from livestock such as cattle and sheep contributes to methane and other greenhouse gas emissions which are causes climate change and global heating. According to an article in The Guardian, around a third of human-caused methane emissions comes from the raising of livestock, mainly from beef and dairy cattle. 8. External costs The external costs of production or consumption refer to the negative externalities (spillover effects or side effects) incurred by those who are not directly involved in the buying or selling of the product in question. For example, a private motorist does not directly pay for the air pollution or the cost of the traffic congestion that they contribute towards. This is a source of market failure because the private costs to motorists in a market economic system do not represent the full economic costs to society. 9. Private costs The private costs of production or consumption refer to the actual costs of economic activity paid by an individual, household, firm, or government. For example, the private costs of motoring to drivers include the cost of buying or financing the vehicle, Grade 9 : Market Failure Chapter registration and licensing feels, the cost of petrol or fuel, road taxes, as well as the maintenance costs. Causes of Market Failure: 1. Public goods Public goods are a source of market failure because due to the lack of a profit motive despite them having external benefits (positive externalities). Firms cannot charge those who are unwilling and/or unwilling to pay (due to the non-excludability of public goods). Furthermore, once provided, the product (such as street lighting or flood control systems) is made available to everyone (due to the non-rivalrous nature of public goods). Essentially, in the private sector of an economy, profit-seeking firms would not be willing to supply public goods due to the free-rider problem - those who do not pay are still able to benefit from the provision of the product once it is provided. Hence, in a market economic system there is an under-provision of production and under-consumption of public goods despite the positive externalities of public goods. 2. Merit goods Merit goods are a source of market failure because of the under-provision and under-consumption despite the external benefits (positive externalities). Merit goods are important for improving standards of living in the economy, although production and consumption are likely to be below the socially optimal levels. Without government intervention, many individuals and households are unable to afford sufficient levels of socially desirable goods and services such as education, healthcare, and housing. For instance, people underestimate the benefits of having a vaccination against viruses such as COVID-19 or tuberculosis. Those who have had vaccinations benefit personally from being protected against diseases. However, there are also external benefits to the rest of society as it reduces infectious diseases being spread in the rest of society. 3. Demerit goods Demerit goods are a source of market failure because the social costs of production and consumption exceed the private costs. For example, the private costs of smoking include the costs incurred by individuals for purchasing the product and the negative impacts of tobacco consumption on the individual such as the higher risks of lung Grade 9 : Market Failure Chapter cancer. The negative externalities of consumption include passive smoking (second-hand smoking) and the pressures imposed on other members of society, such as pressures placed on healthcare services due to the high risks associated with smoking. In a market economic system, without government intervention or regulation, there is over-production and over-consumption of demerit goods, such as: - Drinking (excessive alcohol consumption) – There are private costs including health risks to drinkers plus costs to society as a whole, such as productivity loss in the workplace and the costs associated with greater pressures on public healthcare services. - Recreational drugs – There are private purchase and health costs to users of recreational drugs. In addition, people often underestimate the risks of getting addicted. Costs to society include expenses associated with drug-related crimes, premature deaths, and reduced workdays. - Sugary drinks and snacks – The overconsumption of these demerit goods in a market economic system causes private costs such as tooth decay, diabetes, and obesity. The external costs include the stress placed on family and friends as well as added pressures on the healthcare industry. 4. External costs External costs are a source of market failure as these negative externalities impose additional costs of economic activity on third parties that are not directly involved in the buying or selling of the good or service in question. Examples of external costs include: Air and noise pollution from commercial aircraft. Delays and slower journey times for other drivers due to heavily congestion roads. Drink driving which increases the risks and cases of traffic accidents. 5. External benefits External benefits are a source of market failure because economic activities in the private sector or market economic system cater only for those who are willing and able to pay for private benefit and consumption of goods and services. There is no incentive for profit-maximising firms to supply anything to free-riders. Grade 9 : Market Failure Chapter However, the provision of merit goods and public goods (which exert positive externalities) are under-provided and under-consumed in the market economic system. 6. The abuse of monopoly power A monopoly refers to a single firm dominating the market for a particular good or service. Any firm with significant market share can be said to have some degree of monopoly power, such as Microsoft, Google, and YKK (zips). The abuse of monopoly power is a source of market failure because in a market economic system, being a monopoly enables the firm to charge higher prices (due to the absence of substitutes) or to limit quantity. This distorts the market as consumers pay higher prices and receive less quantity due to the market power of the monopolist. In certain cases of abuse of monopoly power, the government may decide to break up the monopoly as the firm is too powerful and anti-competitive. This would require the monopolist to sell off parts of its business to create opportunities for competition in the market. This should lead to more competitive prices and lower profits for the former monopolist. 7. Factor immobility Factor mobility refers to the extent to which resources (factors of production) can be changed from one use to another purpose in order to produce goods or provide services. For example, well-qualified and highly skilled employees are able to switch between alternative uses (alternative jobs or professions). By contrast, specialist machinery, such as cement mixers, are less mobile in terms of their alternative uses. Factor immobility means that certain products are not suitable for alternative uses. It is a source of market failure because it is difficult for factors of production to move or switch between different uses in the production process due to barriers to productive efficiency. Factor immobility results in the free market being unable to provide an efficient allocation of resources. For example, capital immobility could be a result of the time and/or costs involved in changing or updating machinery, tools, and equipment. Grade 9 : Market Failure Chapter Consequences of Market Failure Recall that market failure occurs when the price mechanism and the forces of demand and supply allocate resources in an inefficient way. The implications of such misallocation of resources in the economy result in any one of two outcomes (or consequences of market failure): Over-consumption (and hence over-production) of demerit goods and products with external costs. Under-consumption (and hence under-production) of merit goods and products with external benefits. Demerit goods create negative externalities (external costs), so are harmful to society as a whole. Such products can be taxed by the government since providing demerit goods at free-market prices would lead to their over-consumption and hence over-production. Merit goods create positive externalities (external benefits), so are beneficial to society as a whole. As they are under-consumed in a market economic system, such products can be subsidised by the government to encourage more consumption and hence production.
