Market Failure

Content
• Externalities in Production and Consumption:
– Positive
– Negative
• Public goods
• Merit goods
• Demerit goods
• Market imperfections
• Inequalities in:
– Wealth distribution
– Income distribution

Externalities
• Externalities result from differences between private
and social costs or benefits
• Externalities can be positive or negative:
– Positive – these have beneficial effects on 3rd parties
– Negative – these are costs that incurred by 3rd parties

External Costs / Negative externalities
• External costs created by businesses can impact the environment in the following
ways:
• Urban blight – excessive development and inappropriate developments mean the
environment is visually less attractive, loss of farmland
• Production and disposal of waste – this could include an increase in litter and
rubbish from packaging
• Use of energy
• Pollution:
– Noise – from cars, lorries, factories etc
– Air – emissions from cars and delivery vehicles
– Land
– Sea
– Water

Negative externalities
• If you consider private
costs then they would
supply along supply curve
S
• Negative externalities
mean that social costs are
higher so the new supply
curve should be S1 and
equilibrium moved to P1

External Benefits / Positive externalities
• As well as external costs businesses can create external
benefits
• External benefits are advantages a business brings to the
local community when it locates its business in a particular
area. These benefits will be positive for the local
community.
• Examples:
• Employment
• Quality of life
• Providing a service
• Regeneration of land

External Benefits / Positive Externalities
• If the business was
supplying products
ignoring social benefits the
initial supply curve S1

External Costs and benefits In production
• External costs are where MSC = MSB – MPC e.g.
pollution, traffic congestion
• External benefits are where MSC < MPC e.g. research and
development in industry, human resource development

External costs and benefits in consumption
• External costs = where MSB < MPB e.g. anti-social
behaviour, passive smoking, noise
• External benefits = where MSB > MPB e.g. public
transport, vaccinations, attractive surroundings

Externalities
• The presence of negative externalities is likely to
cause over production of a product
• The presence of positive externalities is likely to
lead to under production of a product
• Externalities can lead to market failure if the pricing
mechanism fails to account for the social costs and
benefits of production

Value of Externalities
• The value of social costs and benefits can be
measured by looking at:
– Consumer surplus
– Producer surplus
– Cost-benefit analysis : what is the balance of costs and
benefits
– Willingness to pay

Cost Benefit Analysis
• Identify all costs and benefits
• Measure the value of all costs and benefits
• Calculate the likelihood of costs and benefits
• Analyse the timing of the costs and benefits looking
at present value
• Decide whether the project is worth undertaking

Public Goods
• These are services that are provided by the government
• Pure public goods have the following characteristics:
– Non excludability – everyone can consume the goods whether
they pay or not
– Non rivalry in consumption – consumption by one person doesn’t
reduce consumption for others
• Examples – street lighting, national defence

Public goods and Market Failure
• You cant get an individual to pay for public goods
as others can get the benefits from consumption
without paying
• Private companies will not supply public goods as
they don’t make an economic profit on them
• Public goods are only supplied by the government
and financed through taxation

Private goods
• Private goods have the following characteristics:
– Excludability – if you don’t pay you can be excluded
from consuming the product
– Rivalry – the consumption of one person reduces the
amount available for others to consume
– Rejectability – you can choose not to consume them
and therefore reject them

Merit goods
• Merit goods are where social benefits exceed social costs –
they generate positive externalities
• Governments aim to provide more of these goods due to
the benefits to society
• They may subsidise the production of such goods reducing
the marginal costs of consumption and therefore increasing
demand
• Examples – healthcare, education

Merit goods and Market Failure
• If the government didn’t step in and produce merit
goods then they would be under produced
• Attributable to the fact that individuals do not realise
the benefits of consuming these goods

Demerit goods
• Demerit goods are where social costs outweigh
social benefits – they generate negative
externalities
• Governments try and reduce the consumption of
these goods through higher taxes
• Examples – cigarettes, alcohol

Market imperfections
• Monopolies – these are often viewed as allocating
resources inefficiently as the producer is able to
charge higher prices due to being the only producer
in the market
• Imperfect knowledge of the market can also cause
market failure

Immobility of factors of production
• These can lead to market failure and may be due
to:
• Occupational immobility – this occurs when there
are barriers of mobility between different jobs and
different industries
• Geographical immobility exists when there are
barriers to people of moving to different locations

Inequalities
• In market economies an individuals ability to
consume goods and services is dependent on their
income / wealth
• An uneven distribution of income / wealth within an
economy can result in an unsatisfactory allocation
of resources and therefore market failure
• In many developing countries income inequality is
great therefore resulting in misallocation of
resources

Summary
• Externalities are caused when social benefits / costs are different to private benefits / costs
• Positive externalities occur where social benefits are greater than private benefits
• Negative externalities occur where social costs are greater than private costs
• Cost benefit analysis looks at the costs and benefits of producing / consuming a product
• Public goods are goods that are provided by the government e.g. street lighting
• Merit goods are where social benefits exceed social costs e.g. healthcare the government
encourages people to use these
• Demerit goods are where social costs exceed social benefits e.g. smoking the government
discourages people to use these through taxation
• Market imperfections can be caused by monopolies, imperfect market knowledge and factor
immobility which can result in misallocation of resources
• Inequalities in wealth and income distribution may result in a misallocation of resources as
the rich consume more