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Summary Economics edexcel 1.3 market failure revision notes
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Market Failure 1.3Market failure- occurs when the market forces of supply and demand don’t result in an efficient allocation of resources. The
price mechanism doesn’t take into account all the costs/ benefits in the production & consumption of the product or service.
Externalities- costs or benefits to third parties who are not directly part of a transaction between producers & consumers
Positive externality- occurs when the consumption or production of a good causes a benefit to a third party. (Social benefits
> private benefit)
Negative externality- occurs when the consumption or production of a good causes a harmful effect to a third party. (Social
cost > private cost)
Merit goods- goods and services that the government feels that people will under-consume- ought to be subsidised or
provided free at the point of use so that consumption does not depend primarily on the ability to pay for the good or service.
De-merit goods- good which can have a negative impact on the consumer – but these damaging effects may be unknown or
ignored by the consumer. Demerit goods also usually have negative externalities – where consumption causes a harmful
effect on a third party.
Private costs- the costs to the first party who’s either the producer or consumer of the good or service
External costs- the costs to the third party who is neither the producer nor seller. It is the cost in excess private costs. They
are negative spillover effects from the production or consumption which the market fails to take into account.
Social costs- the sum of private costs and external costs: social costs= private costs +external costs
Private benefits- the benefits to the first party who is either the producer or consumer of the good or service
External benefits- the benefits to the third party. It is the benefit in excess of private costs. They are positive spillover effects
from the production or consumption which the market fails to take into account
Social benefits- social benefits are simply the sum of private benefits and external benefits
Information gaps- where consumers, producers or the government have insufficient knowledge to make rational economic
decisions
Symmetric information- where both parties in a transaction (consumer and producer) have the same information
Asymmetric information- where one party in a transaction has more or superior information compared to another
Private goods- goods that have rivalry and excludability in their consumption
Public goods- goods that have non- rivalry and non- excludability in their consumption- not easy to identify who’s
benefitting from the good and so who should pay for it and how much they should pay
Quasi-public goods- semi non rival, semi- non excludable
Non rivalry- one person’s consumption of the good does not affect the amount of the good left for others to consume
Non- excludability- once the good is provided for one person its available to everyone as it is impossible to exclude anyone
from using it
Free rider problem- once a product is provided it is impossible to prevent people from using it and therefore impossible to
charge for it
, Market Failure 1.3
Market failure occurs when a market allocates resources inefficiently and a deadweight loss of
economic welfare. Misallocation of resources
§ A market fails when the price mechanism (forces of supply and demand) fails to allocate
scarce resources efficiently and society suffers as a result
Market failure is a common problem and governments often intervene to try to prevent it
Externalities affect third parties
Externalities are the effects that producing or consuming a good/ service has on people who aren’t involved in the
making, buying/ selling and consumption of the good/ service(‘third parties’)
Positive externalities are the external benefits to a third party and negative externalities are the external costs to a
third party. They can occur in production or consumption
§ A negative externality of producing steel could be pollution that harms the local environment
§ A negative externality of consuming a chocolate bar could be litter that’s dropped on the street
§ A positive externality of producing military equipment could be an improvement in tech that benefit s society
§ A positive externality of someone training to be a doctor could be the benefit to society that this brings
Complete market failure happens where, unless the good/service is provided outside the mechanism, there wouldn’t
be market for it e.g. a country’s’ military services
Partial market failure happens when the private sector may partially provide it but at the wrong price or quantity.
Market failure occurs because externalities are ignored
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 private benefit is the benefit gained by a consumer or a firm doing something
§ 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.
§ Market failure occurs because in a free market the price mechanism will only take into account the private costs
and benefits but not the external costs and benefit
Social optimum position
This is where MSC = MSB and it is the point of maximum welfare. The social costs made from producing the last unit of
output is equal to the social benefit derived from consuming the unit of output
, Negative externalities:
Key ideas:
Negative production externalities: § Bad for the user
§ Bad for society
§ Negative externalities of production occur when social costs are greater
§ Alcohol/ gambling/ drugs
than private costs.
§ Over consumers (QFM >
§ Anything to the right of Qso social cost > social benefit
QSO)
§ The market left to operate freely will ignore the external costs involved in
§ Gov looks to reduce
producing a good. It will produce where MPB=MPC, the market
demand- taxes, subsidies,
equilibrium, at Q1P1.
alternatives, education
§ At Q1, the costs to the society are higher than the benefits to society
(info)
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. Types of market failure
§ The difference between marginal social cost and the marginal private cost § Externalities
increases as output grows, because external costs grow the more that § Under-provision of public
people do something. goods
§ The more people that drive cars, the larger the external cost of pollution. § Information gaps
The noise pollution from airplanes and industrial waste are two examples
of negative production externalities.
,
, Positive externalities (merit goods) - social benefits > private benefits. A greater benefit to society
Key ideas:
§ Good for the user
§ Good for society
Positive consumption externalities § Under consumed
§ Gov looks to increase
§ Positive externalities of consumption occur when social benefits are greater
demand for these e.g.
than costs
renewable energy,
§ In the diagram, the market left to its own devices will produce where
education, solar panels,
MPB=MPC, it will not consider the benefits to society so will produce Q1P1.
electric cars, research
§ 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
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