1. Market Failure
AS Economics

2. Market Failure – a definition
Market failure occurs when the free market, left alone, fails to deliver an efficient allocation of resources. The result is a loss of economic and social welfare.

3. Causes of market failure
Negative externalities e.g. pollution causing the social cost to exceed the private costs
Positive externalities e.g. education causing the social benefit to exceed the private benefits
Imperfect information meaning merit goods are under-produced and demerit goods are over-produced
The private sector being unable to supply important public and quasi-public goods
Market dominance by monopolies
Immobility of factors of production causes unemployment and productive inefficiency
Equity (fairness) issues resulting in an unacceptable distribution of income and social exclusion

4. Activity 1
Which of the following would provide evidence of market failure?
shortages
unemployment
unfilled job vacancies
output occurring inside the PPF

5. Market failure and economic efficiency
MF results in productive inefficiency
Firms are not maximising output from given factor inputs
This is problematic as lost output could have been used to satisfy more needs and wants; resources are misallocated and producing goods and services not wanted by consumers – resources could have been put to better use

6. Externalities
Externalities are costs OR benefits that spill over to third parties external to a market transaction

7. Externalities
Externality – positive or negative depending on costs or benefits
Social costs or benefits
Private
Costs or
Benefits

8. Activity 3
A public house is permitted to stay open all weekend over the May bank holiday. Identify one group of people not directly involved in running or visiting the pub who may:
benefit from this decision
suffer as a result of this decision

9. Negative externalities
Private costs of any action are those suffered by the individual decision maker
Social costs of any action are all the conceivable costs associated with that action
If social costs exceed private costs then a negative externality exists; the private optimum level of output is greater than the social optimum level of output – the individual or consumer does not take into account the effects of externalities into their calculations
PC/SC are usually referred to in the ‘margin’ – the costs or benefits of one extra unit of output
So, MSC = MPC + MEC

10. Positive externalities
These arise when third parties benefit from the ‘spillover’ effects of production and consumption
Education – improves skills and productivity – PB of better for employers – earn more – SB – you increase living standards of the nation
So, MSB = MPB + MEB

11. Activity 4
 Identify:
three private costs a bus company may incur when operating a bus rout
two private benefits a newspaper company can gain from selling its newspapers

12. Activity 5
Identify a benefit the other residents of a street could gain from one household holding a firework party to which they were not invited

13. Activity 6
Identify three negative externalities which villagers may experience as a result of a bypass being built through their village

14. Negative externality S1 (MSC = MPC + MEC) S (MPC) P1 price P D Q1 Q
At price P and demand/supply Q, only the private costs are taken into account
If the external costs are taken into account then the supply curve would shift to the left to S1
Price would rise from P to P1
Equilibrium quantity would fall from Q to Q1
The negative externality is causing over-production of Q-Q1 and the price paid is lower than it should be
S (MPC) P1
price P D Q1 Q
Quantity

15. Positive externality S (MPB) P1 price P D1 (MSB = MPB + MEB) D (MPB) Q
At price P and demand/supply Q, only the private benefits are taken into account
If the external benefits are taken into account then the demand curve would shift to the right to D1
The market equilibrium would be at Price P1 and Quantity Q1
When the market fails to operate in this way there is under-production and this is shown by the difference between Q1 and Q
Too few scarce resources are being used hence the market failure
S (MPB) P1
price P
D1 (MSB = MPB + MEB)
D (MPB) Q Q1
Quantity

16. Recap Negative externalities lead to over-production
Positive externalities lead to under-production
MSC = MPC + MEC
MSB = MPB + MEB

17. Cheap food – at a huge price & questions P91 - 92

18. Merit and Demerit goods
Merit goods are more beneficial for consumers than they realise – usually have positive externalities. Governments usually subsidise these so consumption does not depend on ability to pay
Left to market forces merit goods would be under-consumed and so under-produced (underprovided)
Demerit goods are more harmful for consumers than they realise – usually have negative externalities, and are over-provided

19. Activity 9 Decide whether the following are merit or demerit goods:
heroin
catalytic convertors
insurance
MOT tests
public libraries
education
legal drugs
healthcare
tobacco
vaccinations
alcohol

20. Under-provision of a merit good
S (MSC)
Demand (D) is based on an underestimate of the private benefits of a merit good.
The full benefit to consumers and third parties is represented by the curve D1
Society would gain from increasing output from Q to Q1 P1
price P
D1 (MSB = MPB + MEB)
D (MPB) Q Q1
Quantity

21. Over-provision of a demerit good
S (MSC)
Demand (D) is based on an overestimate of the private benefits of a demerit good.
The full benefit to consumers and third parties is represented by the curve D1
A reduction in output from Q to Q1 would be a move towards a more efficient allocation of resources P
price P1 D D1 Q1 Q
Quantity