Market Failure Terminology (Cambridge International IGCSE Economics)

Defining market failure

Spec point — Defintiion of market failure

• Market failure occurs when the free market fails to allocate resources efficiently, resulting in a loss of social welfare

  • It can lead to too much or too little of a good or service being produced or consumed from society’s point of view
  • For example, pollution caused by factories is not reflected in market prices — this is a market failure

• Free markets often work very well

• However, these free market can fail when there is a less than optimum allocation of resources from the point of view of society

  • Sometimes there is an **over-provision **of goods or services which are harmful (demerit goods) and therefore an over-allocation of the resources (factors of production) used to make these goods/services, e.g., cigarettes
  • Sometimes there is an** under-provision **of the goods or services which are beneficial (public goods and merit goods) and therefore an under-allocation of the resources (factors of production) used to make these goods and services, e.g., schools.
  • Sometimes the market causes a lack of equity (inequality) – the rich get richer and the poor get relatively poorer
  • Sometimes**, environmental damage** occurs during the production or consumption of a good or service

• In each of these cases, from society’s point of view there is a lack of efficiency in the allocation of resources

External costs and benefits

Spec point — public goods, merit goods, demerit goods, private benefits, external benefits, social benefits, private costs, external costs, social costs, monopoly

• Externalities occur when there is an external impact on a third party not involved in the economic transaction between the buyer and seller

  • These impacts can be positive (benefits) or negative (costs) and are often referred to as spillover effects
  • These impacts can be on the production side of the market (producer supply) or on the consumption side of the market (consumer demand)

Costs

Social cost = private cost + external cost

The social cost equals private cost + external cost

• Private costs

  • These are what the producer, consumer or government actually pay to produce or consume a good or service

    • For example, a consumer pays $9 for a McDonald's meal

• External costs

  • These are the damages not factored into the market transaction

    • For example, the consumer throws their McDonald's packaging onto the street and the Government has to hire cleaners to collect the litter

• Social costs

  • These includes both the private cost and the external cost to society

    • It is a better reflection of the true cost of an economic transaction

Benefits

Social benefit = private benefit + external benefit

The external benefits of beekeeping

• Private benefits

  • These are what the producer, consumer or government actually gain from producing or consuming a good or service

    • For example, a bee farmer gains the private benefit of the income from selling their honey

• External benefits

  • An external benefit (positive externality) is the benefit not factored into the market transaction

    • For example, the bees from the bee farm pollinate the nearby apple orchards

• Social benefits

  • These include both the private benefit and the external benefit to society

    • It is a better reflection of the true benefit of an economic transaction

Exam Hint Market failure results in the overconsumption of demerit goods and goods with external costs and the underconsumption of merit goods and goods with external benefits. Your understanding of this concept is frequently tested in MCQ