1. GCSE Economics 3.2 Producing and Consuming
Market Failure

2. Learning Outcomes
Identify, explain and analyse, paying particular attention to pollution, traffic congestion and climate change, ways in which markets may fail to operate efficiently including:
Externalities
The under-provision of merit goods
The over-provision of demerit goods
The under-provision of public goods
Income inequality

3. Market failure
Market failure: When the price mechanism results in an inefficient or unfair allocation of resources.

4. Externalities
Externalities exist when the action of producers or consumers affects not only themselves but also third parties, other than through the normal workings of the price mechanism.

5. Activity
What are the impacts to third parties as a result of the actions below?
Think about both positive and negative effects.
A multi-story car park is built on a plot of empty land in a residential area
Recycling bins are installed throughout a town centre by the local government.

6. Negative Externalities
Negative externality: When the activity of one person or firm has a negative effect on the well-being of a third party not directly involved in the production or consumption of the good or service concerned.
Negative externalities exist when social costs > private costs. In short, when external costs to a third party exist

7. Negative externalities in production
Cost / benefit
Quantity D S2
(Social Cost)
(Private Cost) Q1 Q2 P1
If there are negative externalities in production then the net social cost will be greater than the private cost. For example, the air quality of the local community may be adversely affected by the pollution created by a firm that produces chemicals. The optimum equilibrium for society would be where demand and supply reflect the social cost, i.e. private costs plus external costs.
This occurs at P1 and Q1. However, a free market without government intervention will produce where supply and demand reflect the private costs and benefits at P2 and Q2. If there are negative externalities in production, a free market will therefore tend to over-produce a good.
Text adapted from CCEA GCE course companion
IMAGE DRAWN BY ME

8. Activity - Congestion Charges in London
A congestion charge was first introduced in London in February 2003 at a cost of £5 per day for driving in designated areas between the hours of 07:00 and 18:00.
In June 2014, the congestion charge in London was increased from £10 to £11.50.
Questions
Explain how positive externalities might arise from the implementation of a congestion charge in London.
Could any negative externalities arise from congestion charges?

9. Merit and Demerit Goods
Merit good: A good which the government believes we should consume in greater quantities than would occur under free market conditions. Merit goods often confer positive externalities on society and therefore would be under-consumed if provided through the market.
Demerit good: A good which the government believes we would over-consume under free market conditions. Demerit goods often confer negative externalities on society and therefore would be over-consumed if provided through the market.

10. Activity
Sort the following goods and services into the two categories below and suggest 2 more examples of each
Healthcare
Alcohol
Education
Fast Food
Exercise
Fruit and Vegetables
Merit Goods
Demerit Goods

11. Merit Goods
In the free market there is a misallocation of scarce resources
Merit goods tend to be under consumed as individuals underestimate the true benefit of consumption
Too few scarce resources are used in the production of the good
Therefore there is a misallocation of scarce resources and as a result the market fails.

12. Demerit Goods
In the free market there is a misallocation of scarce resources
Demerit goods tend to be over consumed as individuals underestimate the true harm of consumption
Too many scarce resources are used in the production of the good
Therefore there is a misallocation of scarce resources and as a result the market fails.

13. The importance of information provision
With fuller information consumption of merit goods would increase whilst that of demerit goods would decrease.
Whilst this lack of appropriate information continues scarce resources will be misdirected.
Resources which should be used to increase the production of merit goods will continue to be used in the over production of demerit goods leading to allocative inefficiency and thus market failure.

14. Public Goods Flood controls National Defence Lighthouse
Public good: A good which could not be provided profitably by the market because people could benefit from it without paying, for example, street lighting.
Why might the following goods also be classified as public goods?
Flood controls
National Defence
Lighthouse

15. Why do public goods lead to market failure
The person who pays for a good e.g. lighthouse cannot stop others from using it for free (free rider problem)
This means that no one has the incentive to build the lighthouse as they will bear all of the cost alone resulting in the under provision of public goods.
There is no incentive for private individuals to invest in the goods or services, therefore many public goods e.g. streetlights tend to be provided by the government, otherwise they may not be provided at all.

16. Income Inequality
Income Inequality exists when there are income differentials within different groups of individuals in an economy.

17. Activity
Rank the following countries from top to bottom in terms of which you think have the most unequal distribution of income:
Brazil UK
USA
Sweden
China
South Africa
Iceland
Info taken from
Data based on gini-coefficient (latest year available)

18. Answers
Ranked most unequal – least (global ranking is displayed in brackets):
South Africa – (2)
Brazil (16)
China (28)
US (43)
UK (107)
Iceland (130)
Sweden (142)

19. Sources of Income Inequality
Individuals earn varying levels of income from the following sources:
Wages and salaries
Profits from shares
Rental income from additional property
Interest from savings
Many of the UK’s bottom earners are out of work and receive most of their earnings from welfare benefits

20. Income Inequality in the UK
The top 10% of earners in the UK have salaries which equate to more than the bottom 40% of earners in society combined.
The bottom 40% of households source almost half their earnings from welfare benefits.
The same is true of other economies across the globe. Despite many economies seeing an increase in GDP and economic growth, in many countries the income gap between the rich and poor is widening.

21. Activity
In April 2016 the UK Government introduced the Living Wage. This was to replace the National Minimum Wage for over 25 year olds. The Living Wage of £7.20 was to replace a National Minimum Wage of £6.70
Questions:
How might the Living Wage help to reduce income inequality in the UK?
If a 26 year old were to work 25 hours per week, what difference might they have seen in their weekly wage as a result of the implementation of the Living Wage?
Why might the Living Wage not significantly reduce the problem of income inequality in the UK?