Market Failure

• Market failure

  Occurs when resources aren't allocated in an optimal manner, meaning that the market isn't allocatively efficient, and community surplus isn't maximized
• Negative externalities

  The 'bad' effects that are suffered by the third party, for which the third party doesn't get compensated, when a good or service is produced or consumed
• Positive externalities

  The beneficial effects that are enjoyed by a third party, but not paid for by the third party, when a good or service is produced or consumed
• Demerit goods

  Goods or services considered to be harmful to people who consume them and to society as a whole, that would be over-provided by the free market and so over-consumed
• Merit goods

  Goods or services considered to be beneficial for people who use them and society as a whole, that would be under-provided by the free market and so under-consumed
• Tradable permits

  A market-based solution to negative externalities of production. They are permits to pollute, issued by government, which sets a maximum amount of pollution allowable. Firms may trade these permits for money
• Public goods

  Goods or services which would be under-provided or not provided at all by the free market. They are non-excludable and non-rivalrous, making it pointless for private individuals to provide the good themselves
• Sustainability/Sustainable development

  Where consumption needs of the present generation are met without reducing the ability to meet the needs of future generations
• Types of market failure

  • Lack of public goods
  • Over supply of demerit goods
  • Under-supply of merit goods
  • Existence of externalities
• Lack of public goods

  1. Since public goods are beneficial to society, lack of public goods → Market failure

  2. Examples include roads, flood barriers, street lighting, national defense etc

  3. Public goods are non-excludable and non-rivalrous

  4. Governments reduce this market failure by: Providing the public goods by themselves / Subsidise private firms, cover all costs to provide the public goods
• Over supply of demerit goods

  1. Goods that government thinks that are bad for consumers and society as a whole

  2. Examples include cigarettes, alcohol etc

  3. Governments reduce the demand and supply for the product depending on how harmful they are to the consumers and the society

  4. Some goods will be illegal, but consumption continues due to black markets

  5. Other goods will be taxed so that people can reduce the consumption of the product
• Under-supply of merit goods

  1. Goods that government thinks are beneficial for consumers and society as a whole

  2. Examples include education, health care etc

  3. Governments increase the supply of the product depending on how beneficial they are to the consumers and the society

  4. Some goods will be subsidized, but the amount of subsidy depends on how beneficial the merit good is to the society
• Existence of externalities

  1. Production or consumption of a product have an effect on a third party

  2. When marginal social cost (MSC) = marginal social benefit (MSB), the market reaches full social efficiency and maximum surplus

  3. If that's not the case, then it leads to market failure and inefficient allocation of resources
• Negative externalities

  • Of production
  • Of consumption
• Negative externalities of production

  1. Occurs when the production of a product creates external costs that are harmful for third parties. Examples include environmental problems

  2. Happens when marginal social cost (MSC) > marginal private cost (MPC) + external costs
• Negative externalities of consumption

  1. 'Bad' effects suffered by third parties due to consumers consuming the product

  2. Examples include cigarettes, cars, loud music and noise pollution

  3. Happens where marginal social benefits (MSB) < marginal private benefits (MPB)

  4. There is a welfare loss to society because MSC > MPB

  5. Solutions: Ban cigarette smoking totally / Impose indirect taxes on cigarettes → Reduce consumption of the cigarettes / Provide education about the dangers and produce anti-advertisements about smoking → Reduces demand for cigarettes → MPB shifts to the left

  6. Costs of implementing the solutions: Banning cigarettes wouldn't be simple due to large effect upon the tobacco industry for stakeholders and employment / People might not vote for governments that bans cigarettes / Inelastic demand for cigarettes → Less change in quantity demanded, but doesn't reach the socially efficient level / If taxes are raised too much, people will look for other sources of supply → Formation of black market / Educating and anti advertisements aren't highly effective as people would still smoke after learning about dangers of smoking, so the costs involved in educating and advertising against smoking will be a waste
• Positive externalities

  • Of production
  • Of consumption
• Positive externalities of production


  1. Occurs when production of a product leads to benefits for third parties

  2. Examples include training employees

  3. Happens where marginal private cost (MPC) > marginal social cost (MSC)

  4. There's a welfare gain due to MSC < MPB

  5. Solutions: Subsidize firms that offer training → Shifts MPC curve downwards by the subsidy → MPC = MSC at some point → Reaches socially efficient level / Provide vocational training by setting up training centres for workers in certain industries → Improves quality of labor → Shifts PPC to the right

  6. Costs of implementing the solutions: Very difficult for the government to estimate the level of subsidy deserved by every single firm / Cost of subsidies → Opportunity cost involved → Governments cut their spending on other areas, which are more worthy than the industry they subsidized / Providing training → High costs, firms might lack expertise or dissuade firms from offering training on their own
• Positive externalities of consumption


  1. Occurs when consumption of a product provides external benefits to third parties

  2. Examples include health care and education

  3. Happens where marginal social benefit (MSB) > marginal private benefit (MPB)
• Threats to sustainability

  • High levels of poverty and economic growth → Environment problems such as overuse of land, soil erosion, land degradation and deforestation
  • Problems of common access resources/weak regulations → Massive negative externalities and threat to sustainability
  • Heavy global demand for fossil fuels
  • Extraction and use of coal, oil and natural gas generate external costs → Immense threats to future generations
  • Producers and consumers of such fossil fuels aren't accountable for the external costs for future generations → Fossil fuels are both over-produced and over-consumed → Significant market failure on a global level
• Government responses to threats to sustainability

  • Cap and trade systems
  • Clean technologies
• Cap and trade systems

  Done where governments set national targets for emission reductions and encourage firms to meet the targets by creating an economic incentive to reduce emissions
• Clean technologies

  1. Renewable sources of energy use it as a solution to remove negative externalities from the use and extraction of fossil fuels

  2. Governments can subsidize the development of clean technologies or by offering tax credits to firms that invest in clean technologies
• Lack of public goods

  Market failure
• Public goods

  • Non-excludable
  • Non-rivalrous
• Cap and trade systems

  1. Governments set national targets for emission reductions

  2. Encourage firms to meet the targets by creating an economic incentive to reduce emissions
• Clean technologies

  Renewable sources of energy used as a solution to remove negative externalities from the use and extraction of fossil fuels
• Government subsidies

  1. Lower a firm's production costs

  2. Increasing supply

  3. Give firms an incentive to use higher amounts of clean technologies
• There is an opportunity cost involved as the money spent on the subsidies will not be able to spend on achieving other objectives