Edexcel Economics (A) A-level

Theme 1: Introduction to Markets

and
Market Failure
1.3 Market Failure
Detailed Notes

www.pmt.education
 1.3.1 Types of market failure
Market failure occurs when the market fails to allocate scarce resources efficiently, causing a
loss in social welfare loss. There are three main types of market failure:

● Externalities: An externality is the cost or benefit a third party receives from an

economic transaction outside of the market mechanism. In other words, it is the
spillover effect of the production or consumption of a good or service. This leads to
the over or under-production of goods, meaning resources aren’t allocated efficiently.
For example, ​cars and cigarettes have negative externalities whilst education and
healthcare have positive externalities​.

● Under-provision of public goods: Public goods are non-rivalry and non-excludable,

meaning they are underprovided by the private sector due to the free-rider problem.
The market is unable to ensure enough of these goods are provided. One of the best
examples of a public good is ​streetlights​.

● Information gaps: Homo economicus is assumed to have perfect information,

allowing them to make rational decisions. Similarly, firms are assumed to have
perfect information on their cost and revenue curves and governments are assumed
to know the full cost and benefits of each decision. In reality, this is not the case.
Therefore, economic agents do not always make rational decisions and so resources
are not allocated to maximise welfare. For example, ​consumers do not know the
quality of second hand products, such as cars, and pension schemes are complex so
it is difficult to know which one is best.

1.3.2 Externalities
When there are asymmetric markets, the government provides information to allow people to
make informed decisions. For example, they provide information on smoking and drink
driving. They may force companies to provide information.

Private, external and social costs and benefits:

Private costs/benefits ​are the costs/benefits to the individual participating in the economic
activity. The demand curve represents private benefits and the supply curve represents
private costs.
Social costs/benefits​ are the costs/benefits of the activity to society as a whole.
External costs/benefits are the costs/benefits to a third party not involved in the economic
activity. They are the difference between private costs/benefits and social costs/benefits.

A merit good is a good with external benefits, where the benefit to society is greater than the
benefit to the individual. These goods tend to be underprovided by the free market. A
demerit good is a good with external costs, where the cost to society is greater than the cost
to the individual. They tend to be over-provided by the free market.

www.pmt.education
Externalities diagram look at marginal costs and benefits. A marginal cost/benefit is the extra
cost/benefit of producing/consuming one extra unit of the good. For example, the marginal
private benefit (MPB) is the extra satisfaction gained by the individual from consuming one
more of a good and the marginal social benefit (MSB) is the extra gain to society from the
consumption of one more good. The marginal private cost (MPC) is the extra cost to the
individual from producing one more of the good and the marginal social cost (MSC) is the
extra cost to society from the production of one more good.

Negative production externalities:

Negative externalities of production occur when social costs are greater than private costs.
The market left to operate freely will ignore the external costs involved in producing a good.
It will produce where MPB=MPC, the market equilibrium, at Q1P1.​. At ​ Q1, the costs to the
society are higher than the benefits to society resulting in the loss of welfare equal to the
shaded area. The external cost at Q1 is equal to the line AB. The economy should produce
where MSB=MSC, the social optimum position, at Q2P2. The difference between marginal
social cost and the marginal private cost increases as output grows, because external costs
grow the more that people do something. If one person drove their car, then the external
costs of pollution would be very small. The more people that drive cars, the larger the
external cost of pollution. ​The noise pollution from airplanes and industrial waste are two
examples of negative production externalities.

www.pmt.education
Positive consumption externalities:

Positive externalities of consumption occur when social benefits are greater than social
costs. In the diagram, the market left to its own devices will produce where MPB=MPC, it will
not consider the benefits to society so will produce Q1P1. If the market considers all the
benefits, it would produce where MSB=MSC at Q2P2. The failure of the market to consider
the external benefits has led to the misallocation of resources and so there is an
underproduction of Q1-Q2. This leads to a welfare loss of the shaded area. The line AB
represents the external benefit. Again, the difference between marginal private benefit and
marginal social benefit grows since external benefits grow the more people that undertake
the activity, for example the external benefits of vaccinations are larger the more people that
have the vaccination. ​Healthcare and education are two examples of positive consumption
externalities.

It is ​difficult to work out the size of the externality ​as it tends to be placed on value
judgements, since it is difficult to monetise external costs. Many externalities are involved
with ​information gaps​, as people are unaware of the full implications of their decisions.

Government intervention:

There are a number of ways that the government can intervene to ensure the market
considers the external costs and benefits:

● Indirect taxes and subsidies: ​Taxes can be put on goods with negative externalities
and subsidies on goods with positive externalities. These help to internalise the
externalities, moving production closer to the social optimum position.

● Tradable pollution permits: ​These allow firms to produce up to a certain amount of

pollution, and can be traded amongst firms so give them choice whilst reducing the
total level of pollution.

www.pmt.education
 ● Provision of the good: ​When social benefits are very high, the government may
decide to provide the good through taxation. They do this with healthcare and
education.

● Provision of information: Since some externalities are associated with information

gaps, the government can provide information to help people make informed
decisions and acknowledge external costs.

● Regulation: This could limit consumption of goods with negative externalities, for
example banning advertising of smoking etc.

Government intervention is looked at in more detail in unit 1.4 .

1.3.3 Public goods

Public goods are missing from the free market, but they offer many benefits to society. They
have two key characteristics:

● They are ​non-rivalry​, which means that one person’s use of the good doesn’t stop
someone else from using it
● They are also ​non-excludable​, meaning that you cannot stop someone from
accessing the good and someone cannot chose not to access the good.

A good example of a public good is streetlights as you cannot prevent someone using the
street light nor does their use prevent someone else seeing the light. There are very few
examples of pure public goods, which are non-rivalry and non-excludable.

Free rider problem:

● This says that you ​cannot charge an individual a price for the provision of a
non-excludable good because someone else will gain the benefit from it without
paying anything. A ​free rider is someone who receives the benefits without paying
for it.

● Private sector producers will not provide public goods to people because they ​cannot
be sure of making a profit​, due to the non-excludability of public goods. Therefore,
if the provision of public goods was left to the market mechanism, the market would
fail and so they are ​provided by the government​ and financed through taxation.

www.pmt.education
 1.3.4 Information gaps
● Symmetric information ​occurs where buyers and sellers have potential access to
the same information; this is perfect information. However, many decisions are based
on imperfect information and so economic agents are unable to make an informed
decision; they suffer from an ​information gap​.

● Asymmetric information is when one party has superior knowledge compared to

another. Usually, the seller has more information than the buyer and this means they
can take advantage of the other party’s lack of knowledge, by charging them a higher
price.

● Most ​advertising leads to information gaps as it is designed to change attitudes of

the consumers to encourage them to buy the good. It could cause them to think the
benefits are greater than they actually are. Increases in ​technology mean
information gaps are on the decline as people can get more information.

● Information gaps lead to market failure as there is a ​misallocation of resources

because people do not buy things that maximise their welfare. It means that
consumer demand for a good or producer supply of a good may be too high or too
low, and thus price and quantity are not at the social optimum position. Economic
agents are unable to make rational decisions due to the information gap.

● Some examples of information gaps are: ​drugs, where users do not see the long term
problems; pensions, where young people do not see the long term benefits of paying
into their pension schemes; financial services, where the suppliers have more
information than the consumers so abuse their customers for their own benefit (moral
hazard)​.

www.pmt.education