Market failure
CHARLENE | GCSE ECON
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Resource allocation in market
system
• How does the market system distribute resources?
n The market system allocates economic resources based on the
interaction of demand and supply.
nThe market system creates an equilibrium price and determines
a quantity of output that reflects the demand and supply of
producers and consumers.
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Resource allocation in market
system
• The market system can be an efficient way of distributing
resources because:
n it responds quickly to changes in demand and supply
n it does not need the government to manage it
n it is inexpensive because it does not require government
spending
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What is market failure?
• There are occasions, however, when the market
system leads to resources being allocated in the
“wrong” way.
• Market failure occurs whenever a market leads
to a misallocation of resources.
• A misallocation of resources is means that there
Market failure: when if left
to the market forces of
supply and demand, there is
an inefficient and/or
inequitable allocation of
resources.
may be additional costs and benefits to society
that are not included in the market equilibrium
price.
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Examples of market failure
• For example:
n some goods and services, such as healthcare and education,
may not be consumed or produced in large enough quantities to
maximize the benefits to society.
merit goods
n other goods and services, such as unhealthy foods, may be
overconsumed and overproduced, resulting in additional costs
to society.
demerit goods
nsome goods and services that benefit society, such as street
lighting or national defence, may not be provided at all.
CHARLENE | GCSE ECON
public goods
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Examples of market failure
1.
2.
3.
4.
5.
6.
Missing market for public goods
Externalities
Underconsumption of merit goods
Overconsumption of demerit goods
Information failure
Misallocations in non-competitive market
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Missing market for public goods
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Public goods
• Non-rival (non-diminishable) in
consumption:
p the consumption of a product by one
person does not reduce the amount
available to others.
• Non-excludable:
p non-payers cannot be prevented from
Public goods: are
products that are nonrival in consumption
and non-excludable.
using the product.
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Public goods
• Examples for public goods?
Non-rival in consumption?
Non-excludable?
Ice cream
Crowed sidewalk
National
Defense
Cable TV
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Public goods
• Examples for public goods?
Non-rival in consumption?
Non-excludable?
Ice cream
×
Private goods
×
Crowed sidewalk
×
Quasi public goods
√
National Defense
√
Public goods
√
Cable TV
√
Quasi public goods
×
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Missing market for public goods
• In free market, is there any one that wants to buy or sell such
goods? Why?
p No.
p Since one person pay for it and the others can also benefit
from it for free, nobody wants to pay for it.
p Also no one wants to sell.
p Missing market
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Missing market for public goods
• Why a missing market for public goods is a kind of market failure?
p There is demand for public goods because they are beneficial
to consumers
p But firms are unwilling to supply, and no consumers want to
buy
p Inefficient allocation of resources - market failure
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Missing market for public goods
• Since no private sector wants to sell or buy public goods, who will
get involved?
p government will intervene the market
-- state provision of public goods
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Externalities
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Externalities
• Other names of externality:
p side-effects
p spillover effects
• Third parties:
p someone that is not involved in
the transaction
• Externality can be the result of:
p consumption or production
• Externality can be:
p good (positive) or bad (negative)
CHARLENE | GCSE ECON
Externalities: effects
on third parties due to
the consumption or
production of goods
and services.
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Four situations of externalities
negative
positive
CHARLENE | GCSE ECON
production
consumption
negative externalities
in production
negative externalities
in consumption
positive externalities
in production
positive externalities
in consumption
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Examples
• Negative externalities in production
n production of clothes causing water pollution
Negative externalities in production
occur when the production process results
in harmful effects on third parties.
• Positive externalities in production
n When farmers plant fruit trees, bee keepers also get benefit.
Positive externalities in production
occur when the production process results
in beneficial effects on third parties.
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Examples
• Negative externalities in consumption
n smoking
Negative externalities in consumption:
occur when the consumption process
results in harmful effects on third parties.
• Positive externalities in consumption
n listening to pleasant music
Positive externalities in consumption:
occur when the consumption process
results in beneficial effects on third parties.
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Activity
• Write down positive or negative externalities associated with the
following objects.
n Car
n Factory
n Park or green space
n Education materials
n Hospital
n Cell phone
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Private costs vs. social costs
• When social costs are greater than
private costs
• The difference between social costs
and private costs is
• external cost
• negative externality
• How to calculate social costs?
• SC = PC + EC
CHARLENE | GCSE ECON
Private costs: the costs to
those involved in a
transaction, the costs to
the consumers and firms
involved.
Social costs: the costs or
harmful effects to those
involved in the
transaction (consumers
and firms) and to any
third parties affected.
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Private benefits vs. social benefits
• When social benefits are greater than
private benefits
• The difference between social
benefits and private benefits is
• external benefits
• positive externality
• How to calculate social benefits?
• SB = PB + EB
CHARLENE | GCSE ECON
Private benefits: the
benefits to those involved
in the transaction, the
benefits to the firms and
consumers involved.
Social benefits: the
benefits or beneficial
effects to those involved in
the transaction and to any
third parties affected.
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Social optimum
• When all the social costs and benefits are taken into account, the
social welfare can be maximised.
Social optimum: the quantity
that maximises social welfare
and reflects the social costs and
benefits of an activity.
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Why externalities are market failure?
• However, when private sectors (buyers and sellers) make decisions,
which benefit or cost will they consider?
p Private benefits
p Private costs
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Why externalities are market failure?
• Firms will produce more goods with negative externalities
compared with social optimal - overproduction
• Market failure
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Why externalities are market failure?
• Firms will produce less goods with positive externalities compared
with social optimal - underproduction
• Market failure
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Why externalities are market failure?
• Consumers will consume more goods with negative externalities
compared with social optimal - overconsumption
• Market failure
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Why externalities are market failure?
• Consumers will consume less goods with positive externalities
compared with social optimal - underconsumption
• Market failure
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Under-consumption of merit goods
Over-consumption of demerit goods
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Merit and demerit goods
• The word “judge” implies how we
can classify a merit or demerit good?
p value judgement
- views of what is good or bad,
right or wrong
p what are merit or demerit goods
will vary between countries,
according to moral or political
judgement.
CHARLENE | GCSE ECON
Merit good: a product that
society or government
judges is desirable, too
little is provided by the
market for the benefit of
society as a whole.
Demerit good: a product
that society or government
judges is undesirable, too
much is provided by the
market for the benefit of
society as a whole.
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Merit and demerit goods
• Compared with public goods, the
market for merit and demerit goods
are facing partial market failure
p missing market for public goods
p merit goods could be provided
through the market
p but not enough to maximise social
welfare.
p demerit goods are provided
p but too much to maximise social
welfare
CHARLENE | GCSE ECON
Merit good: a product that
society or government
judges is desirable, too
little is provided by the
market for the benefit of
society as a whole.
Demerit good: a product
that society or government
judges is undesirable, too
much is provided by the
market for the benefit of
society as a whole.
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Merit goods and positive
externalities in consumption
• Examples of merit goods?
p education
p health care
• A merit good can bring
p private benefits to the individual consumer
p external benefits to third parties from their use
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Merit goods and positive
externalities in consumption
• Explain why education is a merit good?
p A good education can allow an individual to get a more highly
paid job.
ü private benefits to the individual consumer
p They will therefore pay more tax, creating additional revenue
for the government. Also, education will create a more highly
skilled workforce that will help the economy to grow.
ü external benefits to third parties
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Demerit goods and negative
externalities in consumption
• Examples of demerit goods?
p cigarettes
p junk food
• A demerit good can bring
p private costs to the individual consumer
p external costs to third parties from their use
-- negative externalities
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Demerit goods and negative
externalities in consumption
• Explain why junk food is a demerit good?
p It is food that can cause health problems if it is eaten too
frequently.
ü private costs to the individual consumer
p Eating too much junk food can create costs to the economy,
because people may work less if they are ill. Also, an
unhealthy diet may increase medical burden to the society.
ü external costs to the third party
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Imperfect information can affect
provision of merit and demerit goods
• Underprovision of merit goods and over provision of demerit
goods may result from imperfect information.
p people may not know the full or long-term effects of actions
they take now
p sometimes even people know the long-term effects, they may
ignore them (myopic (short-sighted), focusing on short-term
satisfaction or utility, not taking account of the long-term costs
and benefits)
p merit goods tend to be underconsumed and underprovided
p demerit goods tend to be overconsumed and over provided
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Costs to society of merit and
demerit goods
• The consumption of demerit goods can lead to negative impacts on
society, such as increased healthcare costs for the government
or reduced economic growth due to lower productivity.
• Underconsumption of merit goods, such as education, may lead to
increased inequality. In the market without government
intervention, not everyone may be able to afford education. Those
who consume less education may have less chance of securing a
highly paid job.
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Imperfect information
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Information failure
• Information failure is where individuals or firms have incomplete
or inaccurate information, resulting in wrong decisions.
• Imperfect information exists when buyers and/or sellers do not
have all the necessary information to make the correct decision
about a product.
• Asymmetric information is a form of imperfect information
where one party (usually the seller) has more or better information
than the other (usually the buyer).
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Information failure
• How imperfect information leads to market failure?
nExample 1: when a student does not know the long-term
benefits of obtaining further qualifications, they may not focus
on studying hard at school. Such merit goods (education) are
therefore underconsumed and underprovided.
nExample 2: users of cigarettes may not know the likelihood of
developing smoking-related diseases later in life or they may
choose to ignore this information. These demerit goods are
therefore overconsumed and overprovided.
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Information failure
• How asymmetric information leads to market failure?
nExample: when selling a second-hand car, the seller has far
more knowledge of its quality than the buyer. This makes it
difficult for buyers to make rational decisions and is a possible
cause of information failure and market failure.
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Misallocations in
non-competitive markets
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Misallocations in
non-competitive markets
• Examples of non-competitive markets?
p Oligopoly
p Monopoly
• Firms in a non-competitive market tend to set higher price or lower
price?
p higher
p For example, a producer in a monopoly could limit supply by
lowering its production.
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Misallocations in
non-competitive markets
• Non-competitive markets have low levels of competition, which
may reduce the standard of living of consumers.
• For example, a firm in a non-competitive market may seek, to
reduce competition by temporarily selling at a lower price than its
rival producer, driving them out of the market, reducing consumers’
choice.
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Government intervention to
reduce market failure
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Methods of government intervention
to counter market failure
• If a government thinks that a market has a misallocation of
resources, meaning there is market failure, it may decide to
intervene in the market.
• The government may decide to influence the market price of a
product or how much of the product is produced. The government
may even decide to ban the product altogether.
• Other methods of government intervention attempt to change
people’s attitudes and behaviour, so that they change their
consumption patterns.
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Methods of government intervention
to counter market failure
• Do you know any methods a government can use to correct market
failure?
• regulation
• government provision
• correcting information failure
• indirect taxation
• subsidies
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Regulation
• Regulation includes rules and laws to correct market failure.
• e.g. banning a demerit good completely
• e.g. passing a law to make it more difficult to buy or supply the
good. (restrictions on the sales and uses of fireworks)
merit goods
• e.g. passing a law to make everyone must be vaccinated against a
demerit goods
particular disease
• e.g. compulsory labeling of nutritional information on food and
drink
CHARLENE | GCSE ECON
information failure
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Government provision
• Some goods or services such as public goods may be
underprovided or not provided at all, by the market system.
• When this happens, the government may decide to organize for the
product to be provided. The government can either provide the
product itself or arrange for another organization to produce it on
behalf of the government.
• It can then decide how to fund these goods or services, such as
through taxation or charging consumers for their use.
p e.g. government provision of education and policing.
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Correcting information failure
• Information failure may lead to overconsumption or under
consumption of certain goods or services, because consumers are
not fully aware the harm or benefit to themselves and to society
caused by their use.
• Correcting information failure involves trying to change people’s
attitudes to consuming a product.
• e.g. The government might discourage the consumption of junk
food by using an advertising campaign showing the harm that it
causes to the body.
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Indirect taxation
• If a government wants to reduce the
consumption or production of a certain
product, for example a demerit good, it
might achieve this by placing a tax on
the firms that make this good.
• A tax on good or service is known as an
indirect tax. Having to pay this tax
would increase the producers’ costs of
production.
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Indirect taxation
• If demand for the product is price elastic, then the
reduction in quantity will be relatively greater
than the percentage increase in price.
• If demand for the product is price inelastic, then
the reduction in quantity will be relatively
smaller than the percentage increase in price.
• This shows that an indirect tax will be more
effective in reducing consumption of a good or
service if demand is price elastic.
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Subsidies
• If a government wants to increase the consumption or production
of a certain product, then it might achieve this by granting a
subsidy to the firms that make this good.
• A subsidy means that money is given to producers to lower their
costs of production. Producers will be more willing to supply their
goods.
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Subsidy
• If demand for the product is price elastic, then the
increase in quantity will be relatively greater than
the percentage decrease in price.
• If demand for the product is price inelastic, then
the increase in quantity will be relatively smaller
than the percentage decrease in price.
• This shows that a subsidy will be more effective
in increasing consumption of a good or service if
demand is price elastic.
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Thank you for
your attention!
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