14.
1 The Nature of Market Failure
Market failure occurs when market forces fail to produce
the products that consumers demand, in the right
quantities and at the lowest possible cost. In other
words, market failure arises when markets are inefficient.
There are a number of indicators of market failure
including shortages, surpluses, high prices, poor quality
and lack of innovation.
If left to market forces, some products may be under-
produced, some over-produced and some may not be
produced at all. Prices may be high due to lack of
competitive pressure and difficulties in lowering the
costs. A lack of investment and reduction in expenditure
on research and development, can also slow down the
improvement in products.
14.2 Failure to take into account all costs and
benefits
• The consumption and production of some products may affect
people who are not involved in their consumption or production
directly (those indirectly affected are often referred to as third
parties)
• In such cases, the total benefits and total costs to society,
called social benefits and social costs, are greater than the
benefits and costs to the consumers and producers, known as
private benefits and private costs. For example, the social
costs of a firm producing chemicals will include costs not only
to the firm, but also to people living nearby.
Costs to third parties are called external costs. Among the
private costs to the firm will be the cost of buying raw materials,
fuel and wages.
The external costs imposed on those living nearby may include
noise pollution, air pollution and water pollution
• The external cost imposed on those living
nearby may include noise pollution, air
pollution and water pollution. If the
decision to produce chemicals is based
only on the private costs to the firm, there
will be over-production.
• Figure 14.1 shows that if only the private
costs to the firm are taken into account,
then the supply would be curve SS,
whereas the full cost to society is higher at
curve SxSx. The difference between the
two is accounted for by the external costs.
The allocatively efficient output is Qx, but
the market output is Q
Third parties: those not directly involved in producing or
consuming a product
Social benefits: the total benefits to a society of an economic
activity
Social costs: the total costs to a society of an economic activity
Private benefits: benefits received by those directly consuming
or producing a product
Private cost: costs bome by those directly consuming or
producing a product
External costs: costs imposed on those who are not involved in
the consumption and production activities of others directly
External benefits: benefits enjoyed by those who are not
involved in the consumption and production activities of others
directly
Socially optimum output: the level of output where social cost
equals social benefit and society’s welfare is maximised
14.3 Information Failure
Producers need to know what products are in demand, where
good quality raw materials can be purchased at lowest possible
prices and what are the most cost-eff ective methods of
production.
If they lack this information, they will make decisions that are not in
their best interests. Besides consumers paying more than required
and buying products of lower quality than available, workers may
end up in the wrong jobs, and producers’ costs may be higher and
revenues lower than possible due to information failure.
14.4 Merit Goods
• Merit goods are products which the government considers
consumers do not fully appreciate how beneficial they are and
so which will be under-consumed if left to market forces. Such
goods generate positive externalities.
• Example: Healthcare
• There are various measures that a government may adopt to
overcome the problem of a lack of consumption. Providing
information on the benefits can help.
14.5 Demerit Goods
• Demerit goods are products which the government considers
consumers do not fully appreciate how harmful they are and so
which will be over-consumed if left to market forces. Such
goods generate negative externalities.
• Example: Cigarettes
• To tackle this problem, a government could raise their price by
imposing a tax on them.
14.6 Public and Private Goods
• Public good is a product which is non-rival and non-excludable
and hence needs to be financed by taxation.
• Example: street lights
• Private good is a product which is both rival and excludable.
• Example: computer
14.7 Abuse of Monopoly Power
• Market failure can arise due to producers having more market
power than consumers.
• Monopoly: a single seller
• Price fixing: when two or more firms agree to sell a product at
the same price.
14.8 Immobility of Resources
• To achieve allocation efficiency, it is necessary for resources to
move from producing products that are decreasing in demand
towards those which are experiencing an increase in demand.
• This requires resources to be both occupationally and
geographically mobile.
• The main measures a government can take to promote
occupational mobility of labour are to improve education and to
provide training in the new skills needed.
14.9 Short-termism
• There is a risk that market forces may not result in sufficient
resources being devoted to capital goods. If a country
produces a high quantity of consumer products, people can
enjoy a high living standard..