Market Failure Booklet

Market Failure
If markets work perfectly then there is an efficient allocation of resources, so resources are allocated
to produce the most goods and services that consumers want.
However, a market failure is when the free market (price mechanism) leads to an inefficient allocation
of resources. The free market means markets operating without government intervention, or allowing
the forces of supply and demand to allocate resources.
1. What is an efficient allocation of resources?
2. What are the 3 functions of the price mechanism?
3. What is meant by a free market?
4. With reference to the incentive function of the price mechanism, why should the market lead to an
efficient allocation of resources

A total market failure would lead to a good or service not being sold, this is a missing market. More
common is a partial market failure when a good is still produced but not at the level which maximises
economic welfare.
5. What is a market failure?
6. What is a total market failure?
7. What is a partial market failure?
8. With reference to an efficient allocation of resources, why does this justify the government intervening
in the economy (ie not leaving it to the market)

Information Asymmetry / Imperfect Information

We assume that there is perfect information so all parties in a transaction know everything about each
other. So, when a customer buys a product, they know everything about the product and know the
price that all other firms are charging for a similar product. Similarly, the business knows everything
about the needs of the customer.
However, when one party knows more than another then this is called information asymmetry and this
can lead to markets failing
9. What is market failure?
10. If there is over supply of goods explain what will happen to mean the market will return to equilibrium
(consider what firms will do to price and the impact on supply and demand)
11. If there is under supply of goods explain what will happen to mean the market will return to
equilibrium (consider what firms will do to price and the impact on supply and demand)
12. What is meant by the assumption of perfect information
13. What is information asymmetry

Used Car Market – the ‘lemons problem’

Economist George Akerlof explained information asymmetry through the ‘market for lemons
problem.’ When someone buys a used car a car might be of good quality (a peach) or poor quality (a
lemon) but the customer does not know which is which.
The customer knows he might be ripped off so is not willing to pay a high price for a used car. This
then means that sellers of ‘peach cars’ are not willing to sell their car as they won’t get a high enough
price for it. Then the market is only left with ‘lemons’ and so customers are only able to buy a low
quality car.
This leads to a market failure as consumers would have been willing to pay a higher price for a ‘peach
car’ but due to information asymmetry customers will not buy a ‘peach’ car at its true price and a
seller is not willing to sell a ‘peach car’ at the reduced price.
This is why the government introduced legal warranties to try and overcome this problem.
14. What is the information asymmetry in the used car market (what does the customer not know?)
15. Why is a customer not willing to pay a high price for a high quality car even if they would be willing to
pay that price if they knew the car was high quality?
16. What will the seller of the high quality do in response if the customer will not pay the ‘peach’ price for
a high quality car?
17. Why does this lead to market failure?
18. Show this on a diagram
19. How does the introduction of warranties help reduce this market failure?

Life Insurance
Life insurance pays out to a customer’s family when they pass away. If someone is high risk
(particularly unhealthy) they are more likely to pass away and so will get charged a higher price for
their insurance. They are likely to still be willing to buy the insurance as they appreciate they are
higher risk. Someone who is lower risk will not be willing to pay such a high price as it is less likely
they will pass away.
20. What is the information asymmetry in the life insurance market? (what do customers know that the
insurance company does not know)
21. Why would an insurer then charge all customers an ‘average’ price?
22. What is the impact of this on low-risk customers

However, the insurer does not know how healthy each customer is and their customers might not tell
the truth about how healthy they are. The insurer knows that customers are not being honest so are
likely to charge an ‘average’ price for insurance.
However, those who are low risk will not be willing to pay the ‘average’ price and so will not buy
insurance. This means the insurer only has medium and high risk customers who are more likely to
make a claim. When they claim the insurer will have to increase their prices. Then only the high risk
customers are willing to buy insurance.
This leads to a market failure as low risk and medium risk customers are unwilling to buy insurance
even though the insurer was willing to sell it at a price they were willing to pay.
23. If low-risk customers leave the market, then what does this mean for the insurers’ profits
24. Why does this lead to an inward shift in supply?
25. Show this market failure on a diagram
26. Explain the market failure caused by this information asymmetry

Anti-Vaccination
There was a campaign to persuade parents to avoid giving MMR vaccinations to their children due to
concerns that the vaccinations caused children to become autistic. Despite a lack of scientific evidence
for, this led (especially in the USA) to a sizable minority of parents refusing to vaccinate children.
The WHO labelled this one of their top 10 health risks of 2019.
27. What is the information failure in the anti-vaccination movement?
28. Show this on a diagram, labelling the market failure
29. What is the market failure caused?
30. Why is this an inefficient allocation of resources if it is based on consumer wants?
Public Goods
For a good to be a public good it must be non-rivalrous and non-excludable.
For a good to be non-rivalrous this means that if one person consumes a good then it does not stop
anybody else from consuming the same good. A shirt is rivalrous because if one person wears it then
another person cannot also wear it.
However, there are some goods that are non-rivalrous. Street lighting in non-rivalrous. Street lighting
makes a street safe for all drivers and pedestrians. The fact that one person benefits from walking
down a brightly lit street does not stop others from enjoying the well-lit street.
Some goods are non-rivalrous up to a certain point. A cinema is initially non-rivalrous as more people
can watch it without stopping others from watching the film, but this stops when the cinema is full.
31. What is meant by non-rivalrous?
32. Why is a can of coke rivalrous?
33. What makes streetlighting non-rivalrous?
34. What makes national defence (like nuclear weapons) non-rivalrous?
35. Why is healthcare rivalrous?
36. Justify if flood defences are likely to be rivalrous or non-rivalrous?
37. Justify if a public park is likely to be rivalrous or non-rivalrous?

A good is non-excludable when you cannot stop someone from purchasing a good even if they have
not paid for it. Most goods are excludable as they have security systems that mean that someone can
only consume a good if it has been paid for.
However, for some goods it is not possible to exclude someone from benefitting from a good even if
they have not paid for it. Using the above example if someone has not paid for street lighting they still
benefit from walking down a well-lit street.
38. What is the difference between a good being non-rivalrous and non-excludable?
39. Why is travelling on the London Underground excludable?
40. Outside Celtic Park there is a large council estate and people on the top floors can watch matches from
their balcony. Why is watching the match non-excludable for them?
41. What makes national defences non-excludable?
42. Explain if the government could make healthcare excludable if they wanted to charge for the NHS
43. Why are flood defences non-excludable?

A public good is both non-excludable and non-rivalrous. A private good is excludable and rivalrous.
44. What does it mean for a good to be rivalrous?
45. What does it mean for a good to be non-excludable?
46. What is a public good?
47. What is a private good?
48. Provide an example of a good being partially rivalrous?

Free Rider Problem

The problem with this is that if customers can consume a product without it affecting others
consumption and does not have to pay for it to enjoy the good then they will just keep consuming the
product without paying for it. This is called the free rider problem.
If this happens then the suppliers will face a reduction in revenue as potential customers are not
buying a product. This means that they will have supply less of the good given reduced profits or if
enough customers are ‘free riding’ and the firm makes a loss they will not supply the product at all.
The market failure is the under supply of public goods. Customers are willing to pay for a product and
firms are willing to provide it at a certain price but due to the nature of public goods, the goods are not
traded. Therefore, typically governments provide these goods.
49. Why are customers unlikely to pay for a good that is non-rivalrous and non-excludable? Use the term
‘free rider’ in your answer
50. Why does this ultimately lead to a reduction in profits of the firm supplying the product
51. What is the market failure caused by this?
52. Why is this a total and not a partial market failure?
53. How can the government providing these goods prevent this market failure from occurring?
54. How does the government ensure that customers will pay for a good even if it is non-excludable?

Quasi-Public Goods
Sometimes a good is only partially rivalrous or excludable. These are referred to as quasi public
goods. For example, if a train was empty it would be non-rivalrous. If it was full it would be rivalrous.
Similarly if there was no ticket barrier or inspectors it would be non-excludable but if they were then
they would be excludable.
55. What is a quasi-public good?
56. How does this differ from a public good?
57. How does it differ from a private good?
58. Why might a road be a qasi-public good even though it is excludable with tolls?
59. Why might technology make this a purely private good now?
60. What is the role of the market (private sector) for a qasi-public good?

Healthcare is a private good but is provided free by the NHS in the UK. Supply is perfectly inelastic
and this leads to excess demand.
61. What is the definition of a private goof?
62. Why is health care rivalrous?
63. Why is it excludable?
64. Why is it still provided by the government if there is no market failure when provided privately?
65. Why is this a normative view?
66. Why will this lead to excess demand?
67. Show excess demand on a diagram?
68. How would the price mechanism prevent this excess demand (consider particularly the rationing
function)

Tragedy of the Commons

The tragedy of the commons is a way of explaining an environmental market failure. When there is a
common area that nobody owns, that the resources will be over-used as nobody is incentivised to
ensure use is sustainable as they do not own the land.
69. What is meant by the commons?
70. Why are the commons non-excludable?
71. Why is it a problem that they are rivalrous?
72. Why would a farmer over-graze if they know it will lead to the land ultimately being destroyed?
73. If each farmers impact on the total commons is small, how can this still destroy the entire common
resource?
74. Why would this be resolved if someone owned this common resource (property rights were allocated)

A modern example is climate change. As nobody owns the environment individuals and firms
continue to over-pollute as if they don’t, they believe others would. As nobody owns the environment,
there is less consideration of long-term sustainability of the environment leading to over production.
The ‘commons’ could include cutting trees in rainforests or overfishing in oceans. One way in which
this could be resolved would be through allocating property rights so that all areas are owned by
someone so there is then an incentive to ensure long term sustainability.
75. Why is it in each fisherman’s short-term interest to ‘over fish’ in a sea?
76. If there are no ownership rights to the sea, why would fisherman not voluntarily agree to fish less?
77. Why is this ultimately detrimental to all fisherman?
78. Why would property rights provide an incentive to fish sustainably?
79. With reference to the tragedy of the commons, explain why individuals and firms are not doing more to
limit CO2 emissions
80. Why could there be less deforestation if somebody owned the Amazon rainforest

Externalities
A transaction has 2 parties, a buyer and a seller. A third party is someone not involved in the
transaction.
The buyer incurs private benefits (utility) and the supplier incurs private costs (costs of production)
when producing the good. We assume that they cannot influence the price as that is determined by a
market equilibrium.
This is called the free market equilibrium because this would be the equilibrium price and output if
we ignored any third parties and only considered the 2 parties to a transaction.
81. Who are the 2 parties directly involved in a transaction?
82. What are the private benefits that a buyer gets from a transaction?
83. What are the private costs that a seller incurs from a transaction?
84. Why would a seller produce less if they incurred higher costs (assuming the same price)
85. What is meant by the term free market?
86. What does a free market equilibrium mean?

It is possible for third parties to also benefit form a good being produced. This is an external benefit
and the total of the MPB and external benefit is the marginal social benefit. Similarly, there could be
an external cost to a good being produced. This means that the marginal social cost is higher than the
marginal private cost. The socially optimal equilibrium is when MSB = MSC
87. What is an external benefit?
88. What is the marginal social benefit?
89. What is an external cost?
90. What is the marginal social cost?
91. What is the free market equilibrium?
92. What is the socially optimal equilibrium?

Negative Production Externalities

Often 3rd parties are negatively affected by a transaction.. This is an external cost as it is incurred a 3rd
party who are not involved in the transaction.
This is a market failure because the equilibrium is not considering all the costs that are involved in the
transaction. The total costs (private and external costs) is the marginal social cost.
93. What is an external cost?
94. Why would a producer having to pay wages to workers making a good not be an external cost?
95. What is meant by the marginal social cost?
96. What is the difference between an external and social cost?
97. What is a negative production externality?
98. What do we know about the level of the negative production externality if the marginal private cost
was the same as the marginal social cost?
If the producer paid the external cost, they would make less profit and so would reduce their supply.
As they are not considering this, they produce more than is optimal for society and so there is a
market failure of over production.
99. Why would a producer usually reduce the quantity supplied if costs increased?
100.Why would they not do this for an external cost?
101.What is a market failure?
102.What market failure is caused by a negative production externality?
103.What is meant by the marginal social cost?

The free market equilibrium occurs where MPB=MPC. The socially optimal equilibrium is the level
of output and price where the
MSB = MSC.
With a negative externality the
free market output is above the
socially optimal output and so the
market failure is over-production
104.What is an external cost?
105.What is meant by the
marginal social cost?
106.At what point would the
free market equilibrium be
107.At what point would the
socially optimal
equilibrium be
108.Draw a diagram showing a marginal private benefit, marginal private cost and marginal social cost
curve following a negative externality
109.What is the market failure caused by a negative externality?
110.What is meant by the welfare loss?
111.Why is there over-production of a good with a negative production externality

Positive Production Externalities

Producing a good can also lead to a positive externality.
Building a new airport runway leads to costs for a producer (labour, tarmac, lights etc) but if other
firms can then transport goods faster it reduces their costs.
This means that the cost to society of building the runway is less than cost to the firm (when you
include others reduced costs), so
the market failure is under-
consumption.
112.What is a positive
production externality?
113.What is the difference
between a positive and
negative production
externality?
114.Why do production
externalities impact cost
curves and not the benefit
curves?
 115.Draw a diagram showing the welfare loss from a production externality
116.Why would a firm with lower private costs increase their production?
117.Why do firms not consider lower costs of third parties and increase their output?
118.What is the market failure caused by a positive production externality?

Positive consumption externalities

It is also possible to have a positive
consumption externality. This is
where consuming a good leads to a
benefit to others not involved in a
transaction. There is an external
benefit and so the social benefit is
greater than the private benefit.
For example, studies show that an
economy grows more when more
people go to university. This means
that there is a marginal social
benefit that is greater than the
marginal private benefit. This leads
to a market failure of under-
consumption.
119.What is a positive
consumption externality?
120.What is an external benefit?
121.Why might ‘consuming’ a university education have a positive externality
122.Why might healthcare have a positive consumption externality?
123.Why would a rational consumer not consider an external benefit when deciding how much to consume?
124.Why is the marginal social benefit above the marginal private benefit for a merit good?
125.Why is the private cost the same as the social cost?
126.Draw a diagram showing the welfare loss caused by consuming a positive consumption externality?
127.What is the market failure caused by a positive consumption externality?

A merit good is a good that the government believe will be under-consumed. This is a values
judgement so a normative statement.
One reason for that is a positive consumption externality. The other reason could be due to imperfect
information, often a consumer does not realise the benefit consuming the good will have on them.
128.What is a merit good?
129.Why is a categorising a merit good a normative statement?
130.What are the 2 reasons why a good can be a merit good?
131.What is the link between a merit good and information asymmetry?
132.Why does imperfect information lead to irrational decisions when consuming a merit good?
133.Why could a university education l lead to information asymmetry and be a positive consumption
externality?

Negative consumption externality

There can also be external costs from consuming a good.
For example, consuming cigarettes can lead to others becoming ill due to passive smoking. Similarly,
if someone consumes fatty foods this makes the more likely to have heart problems and so can impose
a cost on the NHS.
134.What is the external cost of consuming sugary drinks?
135.At what point will a rational consumer stop consuming a good?
136.Why would a rational consumer not consider the external costs to their consumption?
137.With reference to behavioural economics, why might this not be the case?

This means the benefit of consuming these goods to society is less than the good to that consumer and
so MSB is below the MPB. This is because individuals make decisions to buy the good based on their
own utility and not considering the impact on society. This leads to a market failure of over-
consumption which can be shown in a diagram.
138.Why does a negative consumption externality mean
that the marginal social benefit is below the marginal
private benefit?
139.Show this on a diagram, showing the welfare loss
140.At what point is the free market equilibrium
141.At what point is the socially optimal equilibrium?
142.Why do consumers not consider the cost to society of
consuming the good?
143.What is the difference in the market failure caused
by negative consumption and negative production
externalities?
144.What is the difference in the market failure caused
by a negative consumption externality and a positive
production externality?

A de-merit good is a good that the government believes will be over-consumed. This is either because
there is a negative consumption externality or due to information asymmetry consumers do not
appreciate the costs to them of consuming the good.
145.What is a demerit good?
146.What are the 2 reasons a demerit good can lead to over consumption?
147.How does a demerit good differ from a merit good?
148.Why is a demerit good a normative judgement?
149.Why would information asymmetry lead to over consumption of gambling?

Tips on drawing externality diagrams

Step 1: Label your axis Quantity and ‘Price / Costs / Benefits’
Step 2: Draw your marginal private cost and benefit curves
Step 3: Draw an additional curve showing the social costs and benefits (if it is a production
externality draw an additional cost curve, if a consumption externality draw an additional benefits
curve)
Step 4: Show the free market and socially optimal equilibrium
Step 5: Show the misallocation of resources on the X axis
Step 6: Shade the welfare loss triangle (always start the free market equilibrium and move to the
social curve)
150.Which types of externality always has 2 cost curves
151.In a positive production externality which cost is greater?
152.In a negative production externality what cost is greater?
153.What type of externality always has 2 benefit curves?
154.In a positive consumption externality (merit good) which benefit is greater?
155.In a negative consumption externality (demerit good) which benefit is greater?
156.At what point is the free market output?
157.At what point is the socially optimal output?