AQA Specification focus:
‘How public goods, positive and negative externalities, merit and demerit goods, monopoly and other market imperfections, and inequalities in the distribution of income and wealth can lead to market failure.’
Market failure occurs when markets do not allocate resources efficiently. Key phenomena such as externalities, public goods, and monopolies highlight weaknesses in the price mechanism.
Public Goods and Market Failure
Public goods are non-rivalrous and non-excludable, meaning one person’s use does not reduce availability and no one can be excluded from consumption.
Public Good: A product that is non-rivalrous and non-excludable, meaning it cannot be efficiently provided by markets.
Examples include defence, street lighting, and flood barriers. The free-rider problem arises because individuals can benefit without paying, discouraging private firms from supplying them. This results in missing markets and under-provision.
Positive and Negative Externalities
Externalities occur when third parties are affected by production or consumption without this being reflected in market prices.
Externality: A cost or benefit to a third party not accounted for in the market transaction.
Negative externalities (e.g. pollution from factories) impose external costs, leading to overproduction and welfare loss.
Positive externalities (e.g. vaccinations, education) provide benefits to society beyond the private consumer, resulting in underproduction if left to the market.
This misallocation means the market equilibrium diverges from the socially optimal equilibrium.
Merit and Demerit Goods
The distinction between merit and demerit goods relies on value judgments about what society deems beneficial or harmful.
Merit Good: A good that society believes will be under-consumed if left to the market, often with positive externalities (e.g. education).
Demerit Good: A good that society believes will be over-consumed if left to the market, often with negative externalities (e.g. cigarettes).
Imperfect information contributes to their misallocation. Consumers may underestimate the benefits of merit goods or the harms of demerit goods, causing inefficient consumption patterns.
Monopoly and Market Power
A monopoly exists when a firm dominates a market, often defined as a single supplier with over 25% market share in the UK.
Monopoly: A market structure where one firm has significant market power, able to influence prices and restrict output.
Market failure arises because monopolists can:
Restrict output to raise prices, creating deadweight welfare loss.
Exploit consumers through higher prices and less choice.
Reduce innovation and efficiency due to lack of competition.
Thus, monopoly power distorts resource allocation and reduces consumer welfare.
Market Imperfections and Information Failures
Market imperfections arise when the assumptions of perfect competition do not hold. A key source is imperfect or asymmetric information.
Asymmetric Information: A situation where one party in a transaction has more or better information than the other, leading to adverse selection or moral hazard.
Examples include:
Second-hand car markets, where sellers know more about vehicle quality than buyers.
Financial markets, where lenders cannot fully assess borrower risk.
Such information gaps prevent efficient market outcomes and cause misallocation.
Income and Wealth Inequality
Markets may allocate resources efficiently in theory, but the resulting outcomes can create inequalities in the distribution of income and wealth.
Income Inequality: Unequal distribution of income among individuals or households within an economy.
When markets reward scarce skills and capital disproportionately, social welfare can suffer:
Access to healthcare, education, and housing may be restricted for the poorest.
Persistent inequality may reduce equality of opportunity and long-term economic growth.
Externalities may worsen, as poorer households may consume fewer merit goods and more demerit goods.
How These Phenomena Cause Market Failure
The key phenomena identified all disrupt the efficient allocation of resources by the price mechanism:
Public goods: Not provided due to free-rider problem, leading to missing markets.
Externalities: Cause divergence between private and social costs/benefits, misallocating resources.
Merit/Demerit goods: Imperfect information leads to under/over-consumption.
Monopolies: Restrict output and raise prices, harming consumers.
Inequality: Reduces access to essential goods and can exacerbate welfare losses.
By examining each, we see how markets often fail to meet both efficiency and equity objectives, requiring government intervention.
FAQ
Complete market failure occurs when no market exists at all, such as for pure public goods like defence, because firms cannot profitably supply them.
Partial market failure occurs when a market exists but the level of output is inefficient, for example when negative externalities like pollution cause overproduction.
Merit and demerit goods are based on value judgements about what society thinks people should consume, often linked to imperfect information.
Externalities are measurable effects on third parties.
Positive externalities: under-consumption of beneficial goods.
Negative externalities: over-consumption or production of harmful goods.
Merit/demerit classification depends on society’s perception, not just external costs and benefits.
Static inefficiency arises because monopolies restrict output and raise prices, creating deadweight welfare loss.
Dynamic inefficiency occurs when reduced competition weakens incentives for innovation and efficiency improvements. Over time, consumers face fewer product improvements and higher costs.
Lower-income households may lack the ability to pay for goods like education or healthcare, even if they recognise their benefits.
This leads to reduced consumption of merit goods among poorer groups, reinforcing inequality. Government subsidies or state provision are often used to correct this imbalance.
Patients may lack knowledge about treatments or long-term benefits, leading to under-consumption of preventive care (e.g., vaccinations).
Healthcare providers may also hold more information than patients, creating potential for over-treatment or mis-selling. Both cases demonstrate how imperfect information contributes to partial market failure.
Practice Questions
Define what is meant by a public good and explain why such goods are not provided by the market. (2 marks)
1 mark for definition of a public good as both non-rivalrous and non-excludable (must mention both characteristics).
1 mark for explanation that this leads to the free-rider problem, meaning private firms have no incentive to provide such goods.
Explain how negative externalities can lead to market failure, using a diagram in your answer. (6 marks)
1 mark for defining a negative externality (a cost imposed on third parties not reflected in market prices).
1 mark for stating that this leads to overproduction in the market.
1 mark for correctly labelling and explaining the marginal private cost (MPC) and marginal social cost (MSC) curves.
1 mark for identifying the difference between market equilibrium (MPC = MPB) and socially optimal equilibrium (MSC = MSB).
1 mark for noting the welfare loss or inefficiency that arises.
1 mark for clear explanation linking the diagram to market failure.
