MARKET FAILURE

Learning Objectives
1. Define the concept of market failure;
2. Explain the causes of market failure;
3. Discuss the consequences of market failure.

MARKET FAILURE
Market failure occurs when the market forces of demand and supply are unsuccessful in allocating resources
efficiently and cause external costs or external benefits.
Private costs of production and consumption are the actual costs of a firm, individual or government.
External costs (Spill over Effects) are the negative side-effects of production or consumption incurred by third
parties for which no compensation is paid.
Social costs are the true (or full) costs of consumption or production to society as a whole, i.e. the sum of
private costs and external costs.
Social costs = private costs + external costs ------------ (i)
Private benefits are the benefits of production and consumption enjoyed by a firm, individual or government.
External benefits are the positive side-effects of production or consumption experienced by third parties for
which no money is paid by the beneficiary.
Social benefits are the true (or full) benefits of consumption or production, i.e. the sum of private benefits and
external benefits.
Social benefit = private benefit + external benefit ------------- (ii)
Learners Activity
Attempt Chapter Review question 1 and 2 (Cambridge IGCSE and O Level Economics Second Edition, Page
72)
CAUSES AND CONSEQUENCES OF MARKET FAILURE
Causes Market Failure

1. public goods
2. merit goods
3. demerit goods
4. the abuse of monopoly power
5. factor immobility.
Public goods are goods and services that are non-excludable and nonrivalrous. This means those who do not
pay can still enjoy access to the product and there is no competition to purchase or use the product. It causes
market failure because there is lack of profit motive to produce them. Examples are:
» street lighting
» road signs
» law and order
» flood control systems
» national defence
» public fireworks display
» lighthouses
» online search engines
» public roads.
Merit goods are goods or services which when produced or consumed create positive spill over effects in an
economy. These goods have social benefits yet are under-provided and under-consumed without government
intervention or provision. Hence, the social benefits of producing and consuming merit goods outweigh the
private benefits. Examples are:
» education
» healthcare services
» vaccinations
» research and development
» work-related training schemes
» subsidised housing
» museums
» public libraries.
Both the public and private sectors of the economy provide merit goods and services.
Demerit goods are goods or services which when produced or consumed cause negative spill over effects in an
economy. They are a source of market failure because, without government intervention, demerit goods are
over-produced and over-consumed. Examples of demerit goods are:
» cigarettes
» alcohol
» recreational drugs
» junk food
» soda/sugary drinks
» gambling.
Abuse of monopoly power
The existence of a monopoly market can also cause market failure. Without government control, certain private
sector firms could grow to become monopolies and exploit the market by charging higher prices or reducing
supply. In general, profit-maximising monopolists lack incentives to be competitive, so create inefficiencies in
the market.
Factor immobility
This occurs when it is difficult for factors of production to move or switch between different uses or locations.
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. There are two types of factor immobility:
» Geographical immobility — this occurs when it is difficult to move a factor of production from one
geographical location to another.
» Occupational immobility — this occurs when it is difficult to move a factor of production from one type of
work or job role to another.
Learners Activity
Attempt Activity 1 (Cambridge IGCSE and O level Economics Second Edition, Page 71)