2.

10 Market
Failure
 Meaning
• Market failure occurs when the market forces of demand and supply fail to allocate
resources efficiently.
• the production and/or consumption of a good or service causes additional positive or
negative side-effects to a third party not involved in the economic activity.
• If left to market forces, some products may be under-produced, some over-produced and
some may not be produced at all.
 How markets fail
• Lack of public goods – goods that are non excludable and non rivalrous.
• This means those who do not pay can still enjoy access to the product and there is no
competition to purchase or use the product.
• Private sector does not find making public goods profitable.
• e.g. street lights, fireworks displays
• Lack of merit goods - Merit goods are goods or services which when consumed create
positive spillover effects in an economy.
• The greater the consumption of merit goods, the better it is for the economy.
• e.g. education, vaccination.
• There is under consumption of merit goods. Private sector may charge very high prices
for them.
• Provision and consumption of merit goods is below what is socially and economically
optimum.
• Over provision of demerit goods - Demerit goods are goods or services which when
consumed cause negative spillover effects in an economy.
• Private firms may over provide these due to high profitability.
• e.g. alcohol, cigarette
• Consumer and employee exploitation - firms that sell essential products with no close
substitutes may drive prices up for higher profits.
• Monopoly – where the firm controls the supply of the product to the market.
• May pay workers low wages or keep the working conditions poor and dangerous.
• Factor immobility - occurs when it is difficult for factors of production to move or
switch between different uses or locations
• Factor immobility results in the free market being unable to provide an efficient
allocation of resources.
• Over provision of goods with external costs.
• The external costs are the negative spillover effects (or side-effects) of production or
consumption incurred by third parties for which no compensation is paid.
• Under provision of goods with external benefits
• External benefits are the positive side-effects of production or consumption experienced
by third parties for which no money is paid by the beneficiary.
• Information failure occurs due to lack information or inaccurate information.
• There may also be asymmetric information which occurs when consumers and
suppliers do not have equal access to information.
• Workers need to know what jobs are on offer, location, the qualifications required and
salaries.
• consumers to get highest possible satisfaction at the lowest possible prices, should be
fully informed about products on offer, benefits and prices.
• producers need to know demand, where good quality raw materials can be purchased
at lowest possible prices and what are the most cost-effective methods of production.
 Short Terminism
• market forces may not result in sufficient resources being devoted to capital goods.
• For people to enjoy more consumer products in the future, some resources have to be diverted
for making capital goods.
• Private sector firms may be interested in making quick profits and may not plan for times
ahead, resulting in a lack of investment.
• government may have to stimulate private sector investment by, for example, cutting taxes on
firms and undertaking some investment itself.
Externalities
An externality is a cost or benefit of an economic activity experienced by an unrelated third
party.
 Positive externality
• Positive externalities lead to external benefits.
• External benefits are the positive side-effects of production or consumption experienced
by third parties for which no money is paid by the beneficiary.
• education, training and vaccinations.
• They increase satisfaction and lead to economic welfare.
 Negative externality
• Impose external costs.
• The external costs are the negative spillover effects (or side-effects) of production or
consumption incurred by third parties for which no compensation is paid.
• Reduce satisfaction and economic welfare.
• a car driver does not pay for the cost of the congestion and air pollution created when
driving the car.
Private and social costs and benefits
 Private and social costs
• private costs of production and consumption are the actual costs of an individual firm,
household or government.
• The external costs are the negative spillover effects (or side-effects) of production or
consumption incurred by third parties for which no compensation is paid.
• This is an example of market failure as the private costs do not represent the true costs to
society.
• The true cost of an economic activity is called the social cost.
• Social costs = private costs + external costs
 Private and social benefits
• private benefits are the benefits of production and consumption experienced by an
individual firm, household or government.
• External benefits are the positive side-effects of production or consumption experienced
by third parties for which no money is paid by the beneficiary.
• Social benefits are the true (or full) benefits of consumption or production, i.e. the sum
of private benefits and external benefits.
• These are also a market failure because if left to free market, the prices charged for such
products would keep them out of reach for many consumers.
Economic and uneconomic use
 Practice question
• In recent years, a number of agreements have been signed between different countries to
allow more airlines to fly between particular locations, including between Heathrow Airport
in London and the USA. Until 2008, only four airlines – British Airways (BA), Virgin
Atlantic, American Airlines and United Airlines – were permitted to fly between London
and New York. Now a range of airlines including Air France, Air India, British Airways,
Delta, Luft hansa, KLM and Virgin Atlantic fly between Heathrow Airport and the USA.
• a What incentive would encourage more airlines to fly on a particular route?
• b Explain two benefits offered by increased competition to consumers.
• investigate how the following situations give rise to market failure
• A chemicals manufacturer has a choice of either paying for their waster products to be cleaned or dump them,
for free, in a nearby river.
• A river passes through five different countries on its way to the sea. One of the upstream countries decides to
build a dam across the river and use the water to generate electricity and irrigate its crops.

• Billion-dollar dams are making water shortages, not solving them | New Scientist

• Vietnam blames toxic waste water from steel plant for mass fish deaths | Pollution | The Guardian

• SDG 14 – Life Below Water, SDG 15 – Life on Land

• ‘Monopoly’ European airports levy excessive charges, claims A4E | Travel Weekly

• Revealed: Ireland's most affluent and disadvantaged areas - Independent.ie

• create a presentation to the rest of the class explaining how a specified economic activity results in market
failure and whether this market failure results in under- or over-consumption of economic resources