Title: Market Failure and Externalities

Subject : Economics
Author: Deblina Chakraborty

Overview

Imperfections caused within the process of exchange in the market amongst the buyers and
sellers bring about hindrances for the market from performing efficient allocation of scarce
resources available for production and consumption. The note will highlight the issue of
market failure while the market is unable to supply the socially optimal amount of the
commodities and services along with a focus on how externalities in market can contribute
to market failure. This note can be used by students preparing for GCSE, IGCSE, IB, and A-
Level exams.

Market Failure and Externalities

Market Failure
Market failure takes place when the exchange process taking place within the market fails
attaining the criterion of allocative efficiency which remain to be that the value of goods
produced within the market will remain equal to the value of goods that has not been
produced in the market. This is when the price mechanism maintained within the market
fails in considering all the costs and benefits that are necessary for providing as well as
consuming goods and services. Market failure can moreover be regarded as the inability of a
specific market to make an efficient allocation of resources and/or bring about the desired
outcomes within the market.

Some Common Causes Behind A Market Failure

In the scenario of market failure, the major issue remains that there is inefficiency in context
of allocation of commodities and/or services. Thus, when a market failure occurs then the
market is unable to produce the quantity of commodities or services that needs to be
supplied into the market that remains to be socially optimal. So, the situation is that either
there is an overproduction or there is an underproduction. However, to have a clear
understanding regarding market failure, it is very much necessary to identify the core
reasons that may contribute towards the failure of the market. Due to the very structure of
markets in real life, it is certainly not possible for them to be a perfect one. As a
consequence of that, most of the markets are not successful and demand certain forms of

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Title: Market Failure and Externalities
Subject : Economics
Author: Deblina Chakraborty

interventions. Some of the reasons that contribute towards market failure can be
summarised to be as:

 Externalities (Positive Externality and Negative Externality): An externality can be

regarded as an effect or impact brought about on a third party as a consequence of
the consumption of a commodity or service available within the market. While a
positive externality is one that takes place as a positive spillover resulting from the
consumption of certain commodities or services like the attainment of public
education can obviously benefit the students and the schools. But at the same time,
the educated population within a society can bring about a positive impact on the
society as whole. However, while considering a negative externality, it remains
concerned with a negative spillover effect on one or more third parties. For
example, smoking tobacco can be injurious to the health of the individual who is
smoking. Additionally, the smoke that comes out while an individual is smoking may
also directly or indirectly affect the health of other individuals nearby even if the
other individuals are not directly associated with the activity of smoking.
 Insufficiency of public goods: Public goods can be regarded as those goods for
which the total cost of producing a good does not get increased with that of the
number of consumers. For example, for building a highway a specific amount of
fixed cost is needed and that is a specific amount, irrespective of the fact that one
hundred vehicles use it or one billion vehicles use it. The problem with such public
goods is that it can remain to be underproduced. There is a very minimal incentive
associated with production of the public goods. Considering the same example of
building a road, from a private viewpoint, one can wait for someone else to
construct the same and thereafter make use of the same without incurring any sort
of cost. This kind of problem where some individuals benefit from commodities,
services, or resources without making any payment in regard to the cost of
attaining the benefit can be regarded to be as a free rider problem.
 Environmental Considerations: Environment being a common resource for all,
various environmental concerns including pollution caused due to greenhouse

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Title: Market Failure and Externalities
Subject : Economics
Author: Deblina Chakraborty

gases, increasing carbon footprints, and so on contributes towards a massive

misallocation of available resources and thereby bring hindrance in maximisation of
the welfare of the society.
 Abusing the monopoly power: Existence of the invisible hands within the market
ensures the allocation of scarce resources making the total surplus as larger as it
can be possible. In the case of monopoly, the scenario gets changed. Making
unauthorised utilisation of their power, the monopolists can the price level as well
as profit figures higher using the market power and thereby keep the output
generated in the market to remain below the socially optimal quantity of output.
 Excess provision of demerit goods: A demerit good can also be regarded to be a
private commodity that is believed by society to be overconsumed and that in
general generates negative externalities. As an example, we can consider alcohol,
tobacco, cigarettes, etc.
 Inadequate production of merit goods: A merit good can be regarded as private
goods that the society believes to remain under-consumed like healthcare,
education, etc. However, these goods are often associated with bringing positive
externalities.

Externalities Can be a Core Cause Behind Market Failure

Externalities serve to be one of the causes that lead to market failure as in the case of either
of the externalities (either positive or negative) the equilibrium price of the commodity or
service does not provide for a precise and accurate reflection of the true costs as well as
benefits attained from the specific commodity or service. Equilibrium in the market is a
position that represents the absolute and perfect balance between the benefits attained by
the buyers in the market and the costs incurred by the producers resulting into the optimal
level of production in the market. But the existence of such externalities in the market
hampers the equilibrium by providing incentives that can further drive individual actors
within the market to take decisions or perform actions that in turn ends up making
worsening off the entire group or society. In this situation, the scenario of market failure
arises. In case of negative externalities, the producers in the market do not bear all the costs

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Title: Market Failure and Externalities
Subject : Economics
Author: Deblina Chakraborty

resulting into excess production within the market and in case of positive externalities, the
buyers in the market do not attains all the benefits that can be actually attained from a
commodity and as a consequence of that the result remains to be decreased production.

Key Learning Areas

 Market failure occurs when the price mechanism within the free market fails to
allocate resources in an efficient manner and as a result of that the overall society
suffers.
 There can be several reasons for market failure including:
o Externalities (Positive Externality and Negative Externality)
o Insufficiency of public goods
o Environmental Considerations
o Abusing the monopoly power
o Excess provision of demerit goods
o Inadequate production of merit goods
 Both the positive and negative externality can remain to be a core cause behind
market failure.