1. Market Failure
Market failure exists whenever a free market, left to its own devices, fails to deliver economic efficiency
It occurs when the interaction of supply and demand does not lead to productive efficiency and / or allocative efficiency.

2. Market Failure
The normal interaction of supply and demand may lead to the economy:
Producing or consuming too much of some goods.
Producing or consuming too few of some goods.
Or even failing to produce some goods that are needed by society.
In all of these cases, the economy has failed to be economically efficient.

3. Market Failure We will look at three examples of market failure:
Public Goods
Merit and Demerit Goods
Externalities

4. Public Goods The market may fail if it does not provide public goods.
Here, it is not a question of whether the market will supply too much or too little.
Left to its own devices, the market may not supply these goods at all.

5. Public Goods Public goods are defined by two characteristics.
They must be:
Non-excludable.
Once the good is provided for one consumer, it is impossible to stop other consumers benefiting from the good.
Non-rival
As more and more people consume the product, the benefit to those already consuming the product is not diminished.

6. Public Goods: The Market Failure
The market may fail to produce public goods, but why?
Because of the ‘free rider’ principle.
Remember, once one consumer pays for street lights, all other consumers will benefit.
Almost everyone would get a ‘free ride’ at one person’s expense…

7. Public Goods: The Market Failure
Because of the ‘free rider’ principle, consumers wait for someone else to pay for a public good.
They may even conceal their demand for this type of good, to avoid paying for it.
So… people want these goods, but do not register their demand for them.
This means necessary goods are not produced… allocative efficiency cannot be achieved.

8. Merit Goods: The Market Failure
Merit goods will be under-produced in a free market.
Insufficient scarce resources will be allocated to their production.
Insufficient demand is registered in the market, because individuals do not understand how good the product is.
If the information failure did not exist, the ‘correct’ level of demand would be higher.

9. Demerit Goods: The Market Failure
Demerit goods will be over-produced in a free market.
Too many scarce resources will be allocated to their production.
Consumers value the product too highly, because they do not understand how bad the product is.
If the information failure did not exist, the ‘correct’ level of demand would be lower.

10. Merit and Demerit Goods
The definition of a merit good or a demerit good involves information failure related to the knowledge of the consumer.
A merit good is better for a person than they realise.
A demerit good is worse for a person than they realise.

11. Externalities
Economists assume certain things about the interaction of supply and demand:
All market transactions occur between a producer and a consumer.
Each of these involves an economic decision.
Each decision made should only affect the producer and consumer directly involved.

12. Consumption Externalities Production
A problem could arise where someone is not directly involved in an economic decision, is still affected by that decision.
This problem is known as an externality.
Production
Consumption

13. Negative Externalities
Smoking!
When consumers buy cigarettes, there is a difference between the private costs and the social costs.
What are the private costs?
What are the external costs?

14. Negative Externalities
A negative externality exists if there is difference between the private costs and the social costs of a transaction.
The Social Costs are the sum total of the costs related to a transaction
Private costs are the costs that accrue to the decision-makers alone.
Any difference between the two are known as external costs, and must be borne by someone not involved in the transaction, e.g. by society.

15. Negative Externalities
In other words:
If the social costs (SC) of a transaction are greater than the private costs (PC), then external costs (EC) – or a negative externality – must exist:
SC = PC + EC

16. Positive Externalities
Education!
When people pay for education, there is a difference between the private benefits, and the benefits to society.
What are the private benefits?
What are the social benefits?

17. Positive Externalities
A positive externality exists if there is difference between the private benefits and the social benefits of a transaction.
The Social Benefits are the total of the benefits related to a transaction
Private benefits are those that accrue to the decision-makers alone.
Any difference between the two are known as external benefits, and are enjoyed by someone not involved in the transaction, e.g. by society.

18. Positive Externalities
In other words:
If the social benefits (SB) of a transaction exceed the private benefits (PB), then external benefits (EB) – or a positive externality – must exist.
SB = PB + EB

19. Externalities: The Market Failure
When externalities are present, the free market will produce the wrong quantity.
A negative externality will mean that too much of a product is produced.
A positive externality will mean that not enough of a product is produced.
Neither of these situations are economically efficient.

20. Externalities: Exercise
Draw a market diagram to show the market failure for a Negative Externality.
E.g. the Supply and Demand of Cigarettes

21. S2 – (True Social Cost = PC+EC)
S1 – (Private Cost)
D1 – (Private Benefit)

22. Externalities: Exercise
Draw a market diagram to show the market failure for a positive externality
E.g. the Supply and Demand of a vaccination

24. Review Questions What are three different types of Market Failure?
What is the market failing to do?
Can you explain the two defining characteristics of public goods?
What is an externality?
What is the difference between a negative externality and a demerit good?

25. Cost Benefit Analysis CBA
CBA is a technique for assessing the (monetary) social costs and benefits of an investment project or a Government Spending Decision over a given time period
It was developed by public sector economists in order to identify and quantify the social costs and benefits of public sector investment projects
L/O:

26. Does the decision lead to an increase in social welfare?
Examples include:
Basic CBA Process
M1 Motorway 1961
Euro Tunnel
1987
Speed Cameras
1997
L/O: