Chapter 2 - Market Failure

Market failure exists when there is an inefficient allocation of resources in an economy. For
example, such inefficiency would occur when a market does not always produce a desirable
output.

Causes of Market failure

Public Goods

A public good is one that is provided to the whole of a society by a government and is funded
out of taxation.

One cause of market failure is the inability of a market to provide public goods, such as defence,
police or street lighting, because of the free rider problem - a free rider is someone who
consumes a product without paying for it. This means that it is impossible to charge people for
using a public good; no private sector firm would be willing to provide a service if it could not
guarantee its income.

Merit Goods

A merit good is one that exists as a result of information failure.. The demand for merit goods is
lower than would be expected to be the case if everybody had sufficient information about the
potential advantages of the consumption of such goods. However, as a result of information
failure, production and consumption of merit goods is lower than would be the case if full
information had been obtained. Examples of merit good are education, health care and
vaccinations.

Demerit goods

Whereas merit goods are under produced and under consumed in a market, it is the opposite
with demerit goods. There is also information failure with regard to these goods, with people
not fully aware of the harmful consequences of the excessive consumption of goods such as
tobacco or alcohol, so there is overproduction and overconsumption of such goods.

Externality

A private benefit refers to the financial advantages of an economic activity to a particular firm. A
private cost refers to the financial disadvantages of such an activity to a business.

However, economic activity does not only affect the firm carrying out that activity. Very often
there will be consequences for the wider community, for the people living in the area where
economic activity is taking place. When these consequences are beneficial, they are known as
an external benefit and when they have a negative effect on the community, they are known as
an external cost.

When private benefits and external benefits are added together, it gives rise to social benefits.
When private costs and external costs are added together, it gives rise to social costs.

External benefits and costs refer to the benefits and costs to third parties, those people affected
by the decisions of others but who were not involved in taking the decision themselves. Such an
effect is sometimes referred to as a spillover effect. In the case of an external benefit, it is known
as a positive externality, and in the case of an external cost, it is known as a negative externality.

Abuse of monopoly power

A market may fail when there is lack of competition between firms and one firm dominates a
market. Such a firm is called a monopoly. In such a situation, the firm may abuse its monopoly
power, and take advantage of the lack of competition, by increasing the price and reducing the
quality of its output.