Market failure

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 Market failure
• Markets are said to fail when they are
inefficient.
• Market failure arises when:
 Markets fail to produce goods and services
that consumers want
 They fail to produce the quantities of goods
and services required
 They fail to produce goods and services at
acceptably low prices
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 Market failure – an example
• An example of market failure is in the
provision of treatment for children with
HIV and AIDS.
• Large numbers of children in poorer
countries are born with HIV/AIDS.
• They are in desperate need of drugs.
• However, the prices of medicines are so
high and most families cannot afford them.
• The market therefore fails these children.
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 1.Market failure: public goods
• A public good is one that must be provided to
the whole community or not at all, e.g. roads,
police force, street-lighting, parks, fire services,
museums, lighthouses, dams, bridges, etc.
• Public goods have 2 features: they are non-rival
and non-excludable.
• Non-rival means the more one person consumes
will not reduce the amount available to others.
• Non-excludable means that provision of the good
or service is not restricted to one person.

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 Market failure: public goods
• People are reluctant to pay for public goods.
• Those who do not pay would still benefit. They are called
‘free-riders’.
• The private sector / the market would be unwilling to
provide these services because it is very difficult to get the
people who benefit to pay for them.
• In a free market, public goods would not be provided. This
is called a ‘missing market’.
• Thus, the government should provide public goods (roads,
museums, flood defences, law and order, public parks,
street lighting, etc.).

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 2. Market failure: merit goods

• A merit good is one which is more beneficial to an individual than

he realises.
• A merit good has substantial benefits for society as a whole rather than
being restricted to individuals, e.g. vaccination, education, etc.
• There is a market failure because many people would be unable to pay
for health and education services and, thus, would not consume these.
• There would be under-consumption and under-production.
• The under-consumption also occurs because of information failure; i.e.
people are unaware of the full benefits of merit goods.
• Thus, the government should provide merit goods for free or at low
prices.

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 3. Market failure: demerit goods
• A demerit good is one which is more harmful to an
individual than he realises.
• A demerit good has substantial harmful effects for society
as a whole rather than being restricted to individuals, e.g.
drink driving, smoking, unhealthy foods causing obesity
and diabetes, etc.
• There is a market failure because demerit goods are over-
consumed and over-produced.
• The over-consumption also occurs because of information
failure; i.e. people are unaware of the harmful effects of
demerit goods.
• Thus, the government should intervene to reduce the
consumption and production of demerit goods.
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 4. Market failure: externalities

• Some producers and consumers may ignore the harmful

effects of their production and consumption decisions and
activities on other consumers, firms and the environment
because they are only concerned with their own private
costs and benefits.

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 Market failure: externalities

• An externality is the effect of an economic

activity on others.
• It is not taken into account by the individuals who
make a decision.
• It is the external or ‘outside’ effect of a decision,
often called the ‘third party’ effect.
• A favourable external effect is a positive
externality.
• An unfavourable external effect is a negative
externality.
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 Private costs and benefits

• When a business makes a decision, it considers

only its private costs and benefits.
• For example, a businessman in Mauritius is
considering setting up a new factory.
• He will take into account all his private costs and
benefits and will then work out his profit or loss.
• Profit=Total Revenue – Total Costs

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 Private costs and benefits

Private sector firms

Aim: to maximize their profits

Private costs = wages, rents, raw

materials, insurance premiums,
telephone bills, electricity, cost of
borrowing money, etc.
Private benefits = revenue from the
sale of products to consumers

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 Private costs and benefits

Consumers/individuals
Aim: to maximize their
satisfaction

Private costs = money spent on the

good or service

Private benefits = satisfaction from

consumption

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 External costs and benefits
• The businessman will not take into account the
external costs and benefits of his decision.
• External costs = increased pollution from his
factory; loss of profit in a rival business that may
have to close down; jobs lost in the rival factory;
loss of taxes by the government, etc.
• External benefits = jobs created by the new
business; wages of workers; jobs created in
supplier firms; rise in government tax revenue
from profits of the business, etc.

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External costs: pollution

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External costs

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 External benefits

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Social costs: costs to society

Social costs = private costs + external costs

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 Social benefits: benefits to society

Social benefits = private benefits + external benefits

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 An economic use of resources?

If total social benefit > total social cost

 Economic welfare can be improved by

encouraging more production and
consumption

If total social cost > total social benefit

 Economic welfare can be improved by

reducing production and consumption

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 An economic use of resources?
• Activities should only be carried out if the
social benefits are greater than the social
costs.
• The correct equilibrium where social benefits
equal social costs is called the social
optimum quantity.
• It is not always easy to calculate social costs
and benefits and to give a monetary value to
external costs and benefits.
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 Causes of market failure

1. Failure to provide public goods

2. Inadequate provision of merit goods
3. Over-provision of demerit goods
4. Ignoring positive and negative
externalities

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 Causes of market failure

5. Monopoly: A monopoly exists when a

single firm dominates a market and it restricts
output or raises price. For example, some
airline routes between smaller Caribbean
islands are controlled by a monopoly airline.
Prices are often too high for many people. In
Malaysia, Tenaga Nasional Berhad is the only
supplier of electricity.
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 Causes of market failure

6. Factor immobility: Factors of production

are often immobile and cannot move into
areas where they will be more effectively
used. For example, skilled workers may be
unwilling to move from one area of a country
to another (geographical immobility).
Similarly, workers may be reluctant to change
jobs (occupational immobility).
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 Correcting market failure

• A mixed economy combines features of the market economy

with some government intervention; i.e. resources are owned
and controlled by both the private and public sectors.
• Most countries today have strong market sectors combined
with government intervention.
• Market failure provides a justification for government
intervention.
• Government intervention helps to correct or reduce market
failures and to make society better off; i.e. the government
helps markets to work more effectively to allocate scarce
resources.
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 Correcting market failure

• How can a government in a mixed economy ensure that firms

and consumers take account of the external costs and
benefits of their decisions and actions?

India to enforce new regulations to Government unveils plan to tax the

curb noise pollution carbon emissions of the worst
polluters
The Australian government has banned live
cattle exports to Indonesia until safeguards are Tax on landfill to increase by 20% as the government
adopted to end the brutal slaughter of animals attempts to reduce the amount of waste that ends up
in the ground.
The Chinese government announces
South Africa bans plastic bags to
18 recycling projects are to receive reduce litter
government subsidies covering up to
50% of total investment costs Retailers caught handing out the bags now
face a fine of 100,000 rand ($13,800) or a 10-
year jail sentence

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 Correcting market failures
To reduce external costs To increase external benefits
• Raise taxes on firms with activities • Ensure public sector provision of
that create external costs to reduce socially and economically desirable
those firms’ after-tax profits, e.g. goods and services, e.g. providing free
taxes on emissions from the use of vaccinations and education, public
fossil fuels, on landfill waste and parks, public transport and roads
mineral extraction • Provide subsidies to private sector
• Increase indirect taxes on products firms to reduce the cost of activities
and products that have external
that are considered harmful to raise benefits, e.g. subsidies for recycling,
their prices and discourage their renewable energy, organic farming
consumption, e.g. taxes on cigarettes,
• Use regulations to encourage firms to
petrol, plastic bags
change their production methods, e.g.
• Use regulations and fines to rules to phase out traditional light bulbs
discourage the production or to encourage a switch to low-energy
consumption of products or activities light bulbs, health and safety
regulations, animal welfare laws
that are harmful, e.g. smoking bans,
planning controls, legal limits on air
and water pollutants, anti-litter laws
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