Market Failure

MARKET FAILURE
MEANING, CAUSES AND REMEDIES
22/04/2024 David Ako, Ghana International School 1

Meaning of Market Failure
• Market failure occurs when market forces fail
to achieve efficiency in the allocation of scarce
resources.
• It results from the violation of the condition
for allocative efficiency

Cause of Market Failure
• Market failure may be caused by:
• The existence of public goods
• The existence of externalities
• Monopoly power
• Information asymmetry (information failure)
• Income inequalities
• Merit and demerit goods

Private Goods
• Goods that are rival in consumption and
excludable in consumption
– Rivalry in consumption implies that the
consumption of the good by one person reduces
the quantity of the good available to other people.
– Excludability in consumption implies that the good
is only available to those who are able to pay the
price for it.
– E.g.: Yam, cornflakes, bicycles

Public goods
• These are goods that are non-rival and non-
excludable in consumption.
– Non-rivalry implies the consumption of the good by a
person does not reduce the quantity of the good available
to others.
Many people can simultaneously consume the good and
yet the quantity of the good will not reduce.
– Non excludability implies that it is impossible to restrict
the consumption of the good only to those who have paid
for it.
A person can consume the good without paying for it and
it is impossible or impracticable to prevent him/her from
the use of the good.
– E.g.: streetlights, David
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lighthouses, traffic lights
Ako, Ghana International School 5
Public Goods and Market Failure
• These two features of public goods result in
the free rider problem. This is the tendency
for a consumer to consumer the good and
refuse to pay for it.
• The private sector will not allocate resources
to the production of public goods because
they cannot generate revenue from its
production.
• Consequently, market forces fail to allocate
resources to the production of public goods.
Private Costs and Private Benefits
• A private cost is the cost of an activity to an
individual economic unit, such as a consumer
or a firm. For instance, a chemical company will
have to pay for workers, raw materials and
plant and machinery when it produces
chemicals.
• A private benefit is the benefit of an activity to
an individual economic unit, such as a
consumer or a firm. The revenue received from
the sale of a product is a private benefit to the
firm.
Merit Goods and Demerit Goods
• Merit Goods: private goods whose consumption generates
benefits to the consumer directly and to other persons. They
are under consumed because consumers are not fully informed
of the benefits inherent in increased consumption of merits
goods.
• They are goods that the government feels everyone must have
access to because it benefits the entire society if they do. E.g.:
education, healthcare, immunisation
• Demerits Goods: goods whose consumption generates negative
consequences for the consumer and others in society. They are
over consumed because of lack of knowledge of the negative
effects of their consumption
• Governments normally discourage the use of demerit goods.
E.g.: alcohol, narcotic David
22/04/2024 drugs, pollution.
Ako, Ghana International School 8
Merit and Demerit Goods
• Merit goods cause market failure because market
forces produce too little of it although society
desires more.
• People usually consume less education because it
involves cost now although the benefits occur in
future.
• Demerit goods cause market failure because
society is better off if less alcohol and cigarettes
are produced.
• But market forces will produce more of it because
it is profitable to do so.
Externalities
• Externalities are third party or spill over effects arising
from the production and / or consumption of goods
and services for which no compensation is paid.
• There two types of externalities:
• External costs (Negative externalities)
– These are the negative spill over effects of the consumption
and production decisions of economic agents. E.g. Pollution
• External Benefits (Positive externalities)
– These are the positive spill over effects of the consumption
and production decisions of economic agents. E.g.
Reduction in the spread of diseases due to recycling of
waste.
Social Costs and Social Benefits
• Social cost is the cost to the entire society as a
result of the production and/or consumption
of a good or service.
• Social Cost = Private cost + External cost
• Social Benefit is the benefit to the entire
society as a result of production and/or
consumption of a good/service.
• Social Benefit = Private Benefit + External
Benefit
Externalities and Market Failure
• Private firms compare only private benefits and
private cost to determine if the production of a
good is profitable.
• The production of a good to the private firm is
profitable if private cost = private benefit
• Society as a whole compares social cost to social
benefit to determine the desirability of an
economic activity.
• The production of a good is efficiency from
society’s perspective if social cost = social benefit
Positive Externalities and Market Failure
• The recycling of waste yields huge benefits to the

rest of society. The society will better off if more
waste recycling plants are built because they
generate positive externalities.
• But the private firm will not build more waste
recycling plants if they do not think their private
costs will equal private benefits.
• Therefore positive externalities cause under
production and under consumption of recycled
waste (misallocation of resources)
Negative Externalities and Market Failure
• The production and consumption of alcohol is
profitable so private firms allocate resources to its
production. But society will be better off if less
alcohol is produced because it causes negative
externalities (Social cost > social benefit).
• But the private firm will continue to allocate
resources to its production because they find it
profitable (Private cost = Private Benefit)
• Therefore negative externalities cause an
overproduction and overconsumption of alcohol
(misallocation of resources)
Monopoly and Market Failure
• A monopolist is a single producer of a good or
service which has not substitute.
• Monopolies cause market failure because they
have no incentive to increase efficiency and reduce
prices because of the absence of competition.
• They also reduce production in order to increase
price and earn abnormal profit.
• From society’s perspective, the monopolists causes
a misallocation of resources by restricting output
even when society requires increased production.
Information Asymmetry
• Efficient operation of a perfectly competitive
market requires that producers and
consumers are equally well informed and have
perfect knowledge of the market.
• The market fails to achieve efficiency in the
allocation of resources when the parties to a
transaction do not have a perfect knowledge
of the market.

Income Inequalities
• This arises when few people are extremely
rich whilst a larger number of people are poor.
• It causes market failure because the rich have
far more material resources(houses, clothes,
food, cars etc.) than they actually need whilst
the poor cannot afford to feed themselves.
• A more even distribution of income will
improve the collective wellbeing of society
than a skewed one.

Remedies for Market Failure
• Market failure caused by the existence of public
goods can be solved by the provision of those
public goods by government funded through
general tax revenue.
• Where negative externalities cause market failure,
the government could impose indirect taxes
equal to the value of the external costs, impose
permissible pollution limits or compel the firms
concerned to invest in cleaner technologies.

• If the market fails because of external
benefits, the government could provide
subsidies to encourage the production and
consumption of the good.
• The government could nationalise a
monopoly, impose price controls or open up
the industry to competition in order to
resolve market failure caused by monopoly
power.
• Government could increase education and
awareness of the populace about the dangers
associated with the consumption of demerit goods
like alcohol and tobacco. Knowledge of the health
risks will help reduce consumption of such goods.
• Increased education and awareness creation of the
benefits associated with increased consumption of
merit goods like education, exercise, vaccination and
frequent medical checkups.

• Regulation : the imposition of rules and
restrictions on the consumption of demerit
goods: e.g. banning smoking in public places,
age limits for the purchase of alcohol and
cigarettes, and health warnings on cigarette
packets.
• Those who flout the regulations could be
sanctioned through fines and penalties
• Make basic education and vaccinations free
and compulsory
Class Work


Market Failure

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MARKET FAILURE

MEANING, CAUSES AND REMEDIES

22/04/2024 David Ako, Ghana International School 1

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• The recycling of waste yields huge benefits to the

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