CH 14-Market Failure

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2.10 Market Failure YOUR NOTES

2.10.1 Market Failure Terminology
Market Failure Defined

In a free market, the price mechanism determines the most efficient allocation of scarce
resources in response to the competing wants and needs in the marketplace
Scarce resources are the factors of production (land, labour, capital, enterprise)
Free markets often work very well
However, there is sometimes a less than optimum allocation of resources from the point
of view of society. This is called Market Failure
Sometimes there is an over-provision of goods/services which are harmful (demerit
goods) & therefore an over-allocation of the resources (factors of production) used
to make these goods/services e.g. cigarettes
Sometimes there is an under-provision of the goods/services which are beneficial
(public goods & merit goods) & therefore an under-allocation of the resources
(factors of production) used to make these goods/services e.g. schools
Sometimes the market causes a lack of equity (inequality) - the rich get richer and the
poor get relatively poorer
Sometimes, environmental damage occurs during the production or consumption of
a good/service
In each of these cases, from society’s point of view there is a lack of efficiency in the
allocation of resources
Private, Social & External Costs

Externalities occur when there is an external impact on a third party not involved in the
economic transaction between the buyer & seller
These impacts can be positive or negative & are often referred to as spillover effects
These impacts can be on the production side of the market (producer supply) or on
the consumption side of the market (consumer demand)
External costs occur when the social costs of an economic transaction are greater than
the private costs
A private cost for the producer, consumer or government is what they actually pay to
produce or consume a good/service e.g. a consumer pays $9 for a McDonald's meal
An external cost is the damage not factored into the market transaction e.g. the
consumer throws their McDonalds packaging onto the street & the Government has
to hire cleaners to collect the litter
The social cost includes both the private cost & the cost to society
It is a better reflection of the true cost of an economic transaction
Social cost = private cost + external cost
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Private, Social & External Benefits YOUR NOTES
External benefits occur when the social benefits of an economic transaction are greater 
than the private benefits
A private benefit for a consumer, producer or government is what they actually gain
from producing or consuming a good/service e.g. a bee farm gains the private benefit
of the income from selling their honey
An external benefit (positive externality) is the benefit not factored in to the market
transaction e.g. The bees from the bee farm pollinate the nearby apple orchards
The social benefit includes both the private benefit & the external benefit to society
It is a better reflection of the true benefit of an economic transaction
Social benefit = private benefit + external benefit
 Exam Tip
Market failure results in the overconsumption of demerit goods & goods with
external costs & the underconsumption of merit goods & goods with external
benefits. Your understanding of this concept is frequently tested in MCQ.
Page 40 of 61
2.10.2 Causes & Consequences YOUR NOTES

Causes & Consequences of Market Failure
Market Failure occurs when free market activity results in a less than optimum allocation
of resources from the point of view of society
The Causes & Consequences of Market Failure
Cause Explanation Consequences
Demerit Goods These are goods which have They are over-provided in a
harmful impacts on market and their consumption
consumers/society often creates external costs
They are often addictive Governments often have to
E.g. Gambling, alcohol, drugs, regulate these goods in such a way
sugary foods/drinks that they raise the prices and/or
limit the quantities consumed
Merit Goods These are goods that are They are under-provided in a
beneficial to society but market & their consumption
consumers under-consume generates both private and/or
them as they do not fully external benefits
recognise the private or Governments often have to
external benefits subsidise these goods in order to
E.g. Vaccinations, education, lower the price and/or increase the
electric cars quantities consumed
Public Goods Public goods are beneficial to Non-excludability refers to the

society but would be under- inability of private firms to exclude
provided by a free market as certain customers from using their
there is little opportunity for products. In effect, the price
sellers to make profits from mechanism cannot be used to
providing these exclude customers e.g. street
goods/services as they are lighting
non-excludable and non- Non-rivalry refers to the inability of
rivalrous in consumption the product to be used up, so there
Good examples include is no competitive rivalry in
national defence, parks, consumption to drive up prices and
libraries and lighthouses generate profits for firms
Therefore, governments will often
provide these beneficial goods
themselves, and so they are called
public goods
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Abuse of The development of monopoly The outcome is that

YOUR NOTES
Monopoly Power markets is a natural outcome of goods/services are purposely 

a market system under-provided in order to raise
Firms seek to eliminate prices and profits
competition by buying out Governments often intervene to
competitors & increasing their ensure that there is healthy
ownership of factors of competition in markets &
production sufficient provision of
With less competition, firms goods/services
can raise prices, reduce the
choice available to consumers,
or limit the supply
Factor Factor immobility occurs Factor immobility results an

Immobility when it is difficult for factors of inefficient allocation of resources
production to move or switch in a market (usually under-
between different provision)
uses/locations Governments often implement
The two main types of factor programs to reduce the factor
immobility are the immobility in order to raise
geographical & occupational production & output
immobility of labour
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YOUR NOTES
External Costs & Externalities occur when there A positive externality of 

Benefits is an external cost or benefit consumption occurs when there is
on a third party not involved in a positive external benefit in
the economic transaction consumption, such as when
These impacts can be positive electric vehicles are consumed
or negative CO2 emissions fall
The price mechanism in a free A positive externality of
market ignores these production occurs when there is a
externalities positive external benefit in
If these external costs/benefits production, such as when
were acknowledged, then the managed pine forests produce
price and output in the market timber but also increase CO2
would be different absorption
A negative externality of
consumption occurs when there is
an external cost in consumption
such as when the consumption of
alcohol increases anti social
behaviour
A negative externality of
production occurs when there is
an external cost in production such
as when the production of
electricity increases air pollution
 Exam Tip
When explaining externalities, your syllabus focusses on the external costs &
benefits. It does not specifically refer to negative/positive externalities of
production or consumption. That language has been included here as it helps to
deepen your understanding which will help you to better answer both MCQ &
structured questions on market failure. You can use this economic language
knowing it will enhance your answers.
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2.10.3 Government Intervention to Address Market Failure YOUR NOTES

Intervention to Address Market Failure
Four of the most commonly used methods to address market failure in markets are indirect
taxation, subsidies, maximum prices, & minimum prices
Additional methods of intervention include regulation, nationalisation, privatisation, &

State provision of public goods
 Exam Tip
The material on this page is frequently examined in the Paper 2 structured questions.
You will be asked to evaluate the effectiveness of taxes, subsidies, maximum &
minimum prices. To do so:
1. Consider the advantages & disadvantages of each method of intervention
2. Explain that several methods of intervention are likely to be more effective than a
single method e.g. smoking is taxed & highly regulated (age restrictions,
packaging restrictions, display restrictions)
3. Consider different market segments & their responsiveness e.g. wealthy
consumers will less responsive (inelastic demand) to tax increases than poorer
consumers (elastic demand)
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Maximum Prices YOUR NOTES
A maximum price is set by the government below the existing free market equilibrium 
price & sellers cannot legally sell the good/service at a higher price
Governments will often use maximum prices in order to help consumers. Sometimes they
are used for long periods of time e.g. housing rental markets. Other times they are short-
term solutions to unusual price increases e.g. petrol
The maximum price (Pmax) sits below the free market price (Pe) & creates a condition of
excess demand (shortage)
Diagram Analysis
The initial market equilibrium is at PeQe
A maximum price is imposed at Pmax
The lower price reduces the incentive to supply & there is a contraction in QS from Qe
→ Qs
The lower price increases the incentive to consume & there is an extension in QD from
Qe → Qd
This creates a condition of excess demand QsQd
The Advantages & Disadvantages of Using Maximum Prices
Advantages Disadvantages
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YOUR NOTES
Some consumers benefit as they Some consumers are unable to purchase

purchase at lower prices due to the shortage 
They can stabilise markets in the short- The unmet demand usually encourages
term during periods of intense disruption the creation of illegal markets (black/grey
e.g. Covid supplies at the start of the markets) as desperate buyers turn to
pandemic illegal bidding
Maximum prices distort market forces &
therefore can result in an inefficient
allocation of scarce resources e.g.
maximum prices in rentals in the property
market create a shortage
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Minimum Prices YOUR NOTES
A minimum price is set by the government above the existing free market equilibrium price & 
sellers cannot legally sell the good/service at a lower price
Governments will often use minimum prices in order to help producers or to decrease
consumption of a demerit good e.g. alcohol
The imposition of a minimum price (Pmin) above the free market price (Pe) creates a
condition of excess supply (surplus)
Diagram Analysis
The initial market equilibrium is at PeQe
A minimum price is imposed at Pmin
The higher price increases the incentive to supply & there is an extension in QS from
Qe → Qs
The higher price decreases the incentive to consume & there is a contraction in QD
from Qe → Qd
This creates a condition of excess supply QdQs
The Advantages & Disadvantages of Using Minimum Prices In Product Markets
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In agricultural markets, producers benefit It costs the government to purchase the

YOUR NOTES
as they receive a higher price excess supply & an opportunity cost is 

(Governments will often purchase the involved
excess supply & store it or export it)
Farmers may become over-dependent
When used in demerit markets, output on the Government's help
falls (Governments will not purchase the
excess supply of a demerit good) Producers lower output which may result
in an increase in unemployment in the
Producers usually lower their output in industry
the market to match the QD at the
minimum price & this helps to reduce the
external costs
Minimum Prices in Labour Markets
Minimum prices are also used in the labour market to protect workers from wage
exploitation
These are called national minimum wages
A national minimum wage (NMW) is a legally imposed wage level that employers must
pay their workers
It is set above the market rate
The minimum wage/hour varies based on age
A national minimum wage (NMW1) is imposed above the market wage rate (We) at W1
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Diagram Analysis YOUR NOTES
The demand for labour (DL) represents the demand for workers by firms 
The supply of labour (SL) represents the supply of labour by workers
The market equilibrium wage & quantity for truck drivers in the UK is seen at WeQe
The UK government imposes a national minimum wage (NMW) at W1
Incentivised by higher wages, the supply of labour increases from Qe to Qs
Facing higher production costs, the demand for labour by firms decreases from Qe to Qd
This means that at a wage rate of W1 there is excess supply of labour & the potential for
unemployment equal to QdQs
The Advantages & Disadvantages of a Minimum Wage In Labour Markets
Guarantees a minimum income for the Raises the costs of production for firms
lowest paid workers who may respond by raising the price of
Higher income levels help to increase goods/services
consumption in the economy If firms are unable to raise their prices, the
May incentivise workers to be more introduction of a minimum wage may force
productive them to lay off some workers (increase
unemployment)
Page 49 of 61
Indirect Taxation YOUR NOTES
An indirect tax is paid on the consumption of goods/services 

It is only paid if consumers make a purchase
It is usually levied by the government on demerit goods to reduce the quantity
demanded (QD) and/or to raise government revenue
Government revenue is used to fund government provision of goods/services e.g
education
Indirect taxes are levied by the government on producers. This is why the supply curve
shifts
Producers and consumers each pay a share (incidence) of the tax
The impact of an indirect tax is split between the consumer (A) & the producer (B)
Diagram Analysis
The government places a specific tax on a demerit good
The supply curve shifts left from S1→S2 by the amount of the tax
The price the consumer pays has increased from P1 before the tax, to P2 after the tax
The price the producer receives has decreased from P1 before the tax to P3 after the tax
The government receives tax revenue = (P2-P3) x Q2
The consumer incidence (share) of the tax is equal to area A: (P2-P1) x Q2
The producer incidence (share) of the tax is equal to area B: (P1-P3) x Q2
The QD in this market has decreased from Q1→Q2
If the decrease in QD is significant enough, it may force producers to lay off some
workers
The Advantages & Disadvantages Of Indirect Taxes
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YOUR NOTES
Reduces the quantity demanded of The effectiveness of the tax in reducing

demerit goods the use of demerit goods depends on the 
Raises revenue for government programs price elasticity of demand (PED)
Many consumers who purchase
products that are price inelastic in
demand will continue to do so
It may help create illegal markets as
consumers seek to avoid paying the taxes
Producers may be forced to lay off some
workers as output falls due to the higher
prices
 Exam Tip
This further develops the exam tip mentioned above. When analysing the impact of
taxes on a market it is worth highlighting the elasticity of the product as it
influences who pays more of the tax (producer or consumer).
The more price inelastic the product, the greater the proportion of the tax will be
passed on to consumers by producers as the QD will fall less proportionately than
the price increase. The more price elastic the product, the smaller the proportion of
the tax will be passed on to consumers by producers as the QD will fall more
proportionately than the price increase. (See sub-topic 2.7.2 for more on PED)
Page 51 of 61
Producer Subsidies YOUR NOTES
A producer subsidy is a per unit amount of money given to a firm by the government 
To increase production
To increase the provision of a merit good
The way a subsidy is shared between producers & consumers is determined by the price
elasticity of demand (PED) of the product
Producers keep some of the subsidy & pass the rest on to the consumers in the form
of lower prices
A diagram which demonstrates the cost of a subsidy to the government (A+B) and the share
received by the consumer (A) & producer (B)
Diagram Analysis
The original equilibrium is at P1Q1
The subsidy shifts the supply curve from S → S + subsidy:
This increases the QD in the market from Q1→Q2
The new market equilibrium is P2Q2
This is a lower price and higher QD in the market
Producers receive P2 from the consumer PLUS the subsidy per unit from the government
Producer revenue is therefore P3 x Q2
Producer share of the subsidy is marked B in the diagram
The subsidy decreases the price that consumers pay from P1 → P2
Consumer share of the subsidy is marked A in the diagram
The total cost to the government of the subsidy is (P3 - P2) x Q2 represented by area A+B
The Advantages & Disadvantages Of Producer Subsidies
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Can be targeted to helping specific Distorts the allocation of resources in

YOUR NOTES
industries markets e.g. it often results in excess 

Lowers prices & increases demand for supply when used in agricultural markets
merit goods There is an opportunity cost associated
Helps to change destructive consumer with the government expenditure - could
behaviour over a longer period of time e.g. the money have been better used
subsidising electric cars makes them elsewhere?
affordable and helps motorists to see Subsidies are prone to political pressure
them as an option for the masses - & not & lobbying by powerful business interests
just the elite e.g. most oil companies receive subsidies
from their respective governments
(despite making $billions in profits each
year)
Page 53 of 61
Other Government Policy Measures to Address Market Failure YOUR NOTES
Other Methods Used to Address Market Failure 
Method Explanation Advantages Disadvantages
State Provision Public goods are They are usually Paid for through
of Public Goods beneficial for society & provided free at general taxation
are not provided by the point of There is an
private firms due to the consumption opportunity cost
free rider problem Accessible to associated with
Examples include roads, everyone their provision
parks, lighthouses, regardless of Products which
national defence income are free may result
Usually provide in excess
both private & demand & long
external benefits waiting times e.g.
to society procedures at
Public hospitals
Page 54 of 61
YOUR NOTES
Privatisation Privatisation occurs Increases Government

when governments government assets are often 
transfer ownership & revenue in the sold well below
control of firms/assets year the asset is their actual
from the State (public sold market value
sector) to the private Private firms may Private firms often
sector (private firms) run the business provide a sub
Many State firms are more efficiently standard
monopolies. By The government good/service as
privatising them it no longer needs to they cut quality to
encourages more manage the increase profits
competition in those business or hire The price of the
markets people to work for good/service
This should result in more it - this reduces usually increases
efficiency & lower prices government as firms seek to
for consumers expenditure maximise their
profit e.g. energy
prices in the UK
market
Many privatised
companies still
maintain
considerable
market power &
have to be
regulated, e.g.
water companies
Page 55 of 61
Nationalisation Nationalisation occurs This can generate Government firms

YOUR NOTES
when the Government efficiencies, can often run very 

takes control & especially when inefficiently
ownership of firms which delivering utilities There is an
were in the private sector (gas, water, opportunity cost
electricity) to the associated with
national the money
population required to run it
It creates more The Government
equity in society may lack the
as all citizens have expertise to run
the same access the business
to the same
resource at the
same price e.g.
Norway
nationalised much
of the oil industry
when oil was first
discovered in
1972. The profits
belong to the
citizens
The business can
generate
significant
revenue for
government
Page 56 of 61
Regulation Governments create Individuals or firms Enforcing laws

YOUR NOTES
rules to limit harm from may be requires the 

the external costs of fined/imprisoned government to
consumption/production for breaking the hire more people
They often create rules e.g. selling to work for the
regulatory agencies to cigarettes to regulatory
monitor that the rules are minors is a agencies
not broken punishable Enforcing laws
offence can be difficult as
They help to it is a complex
reduce the process to
external costs of determine if
demerit goods firms/consumers
Fines can are breaking the
generate extra laws
government The regulation
revenue may create
underground
(illegal) markets
which could
generate even
higher external
costs on society
Page 57 of 61

CH 14-Market Failure

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2.10 Market Failure YOUR NOTES

Market Failure Defined

Free markets often work very well

Private, Social & External Costs

Private, Social & External Benefits YOUR NOTES

2.10.2 Causes & Consequences YOUR NOTES

The Causes & Consequences of Market Failure

Cause Explanation Consequences

Public Goods Public goods are beneficial to Non-excludability refers to the

Abuse of The development of monopoly The outcome is that

Monopoly Power markets is a natural outcome of goods/services are purposely 

Factor Factor immobility occurs Factor immobility results an

External Costs & Externalities occur when there A positive externality of 

2.10.3 Government Intervention to Address Market Failure YOUR NOTES

Additional methods of intervention include regulation, nationalisation, privatisation, &

Maximum Prices YOUR NOTES

The Advantages & Disadvantages of Using Maximum Prices

Some consumers benefit as they Some consumers are unable to purchase

Minimum Prices YOUR NOTES

The Advantages & Disadvantages of Using Minimum Prices In Product Markets

In agricultural markets, producers benefit It costs the government to purchase the

as they receive a higher price excess supply & an opportunity cost is 

Minimum Prices in Labour Markets

Diagram Analysis YOUR NOTES

The Advantages & Disadvantages of a Minimum Wage In Labour Markets

Indirect Taxation YOUR NOTES

An indirect tax is paid on the consumption of goods/services 

Producers and consumers each pay a share (incidence) of the tax

The Advantages & Disadvantages Of Indirect Taxes

Reduces the quantity demanded of The effectiveness of the tax in reducing

Producer Subsidies YOUR NOTES

The Advantages & Disadvantages Of Producer Subsidies

Can be targeted to helping specific Distorts the allocation of resources in

industries markets e.g. it often results in excess 

Other Government Policy Measures to Address Market Failure YOUR NOTES

Other Methods Used to Address Market Failure 

Method Explanation Advantages Disadvantages

Privatisation Privatisation occurs Increases Government

Nationalisation Nationalisation occurs This can generate Government firms

when the Government efficiencies, can often run very 

Regulation Governments create Individuals or firms Enforcing laws

rules to limit harm from may be requires the 

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