MARKET FAILURE

Definition: Failure of the market to allocate (distribute) resources efficiently

- Too much or too little of a good is produced and consumed
- The production and consumption of a good/service causes positive or negative
side-effects to a third party not directly involved in the production to consumption of
that good or service.
Third party examples: communities who live around a polluting factory or people who
live around a private golf course

PRIVATE, EXTERNAL AND SOCIAL COSTS

Private cost: Costs borne by those who are directly involved in the production and
consumption of goods and services e.g: costs of fuel/petrol
External costs: Costs imposed on those who are not directly involved in the
production and consumption of goods and services. e.g: costs of congestion
Social costs: Private cost + External costs. e.g: private costs + external costs $11.00

PRIVATE, EXTERNAL AND SOCIAL BENEFITS

Private benefits: Benefits received by those who are directly involved in the
production and consumption of goods and services. E.g: money saved on fuel
External benefits: Benefits received by those who are not directly involved in the
production and consumption of goods and services. E.g:lower traffic
Social benefits: Private benefits + External benefits. E.g: Private costs + external
benefit $10.00

THE IDEAL SCENARiO

- Markets shouldn’t produce too much (overallocation of resources) or too little
(under-allocation of resources).
- For markets to be efficient, they should produce an optimal level for society (a
quantity of output that brings the greatest benefits for society)

CAUSES OF MARKET FAILURE

- Market failure occurs when the price mechanism fails to allocate resources
efficiently
1. When social costs exceed social benefits: when the costs for society of a good are
greater than the benefits society gets by consuming them. E.g: consumption of
cigarettes.

UNDERCONSUMPTION OF MERIT GOODS

Merit goods: goods that are beneficial to the individual and society as a whole, and
are usually under-consumed in a free market.