Cambridge Syllabus Notes

Allocation of Resources – Market Failure

Learning Objective

Define market failure, recognise the situations in which it arises, describe its consequences and outline the main government interventions used to correct it (Cambridge IGCSE 0455 – 2.9 Market failure).

1. Definition of Market Failure

A market failure occurs when a free market, left to operate without government intervention, does not allocate resources efficiently. In other words, the market outcome is not Pareto‑efficient; the total welfare of society is lower than it could be because the quantity of a good or service produced and consumed is not the one that maximises the net benefit to society.

2. Why Efficient Allocation Matters

In an efficient market the marginal benefit (MB) to consumers of the last unit produced equals the marginal cost (MC) to producers of that unit:

MB = MC

If MB > MC, society would be better off producing more of the good.
If MB < MC, producing less would increase welfare.

Market failure means this equality does not hold.

3. Key Syllabus Terms (definitions)

Private cost / private benefit: the cost or benefit that falls on the buyer or seller directly involved in the transaction.
Social (or external) cost / social (or external) benefit: the cost or benefit that falls on third parties who are not part of the transaction.
Externality: a situation in which private marginal cost/benefit diverges from social marginal cost/benefit.
- Negative externality – social cost > private cost.
- Positive externality – social benefit > private benefit.
Public good: a good that is non‑rivalrous (one person’s use does not reduce another’s) and non‑excludable (people cannot be prevented from using it). Example: national defence.
Merit good: a good or service that provides more benefit to society than consumers recognise, leading to under‑consumption if left to the market. Example: secondary education, vaccination.
De‑merit good: a good or service that imposes more cost on society than consumers recognise, leading to over‑consumption if left to the market. Example: tobacco, alcohol.
Monopoly (market power): a market structure in which a single seller controls the supply of a good and can set the price above the competitive level, causing under‑production and higher prices. It is listed in the syllabus as a *cause of market failure*.

4. Causes of Market Failure (syllabus requirement)

Externalities – arise because private marginal cost or benefit diverges from social marginal cost or benefit.
Public goods – arise because the good is non‑rival and non‑excludable, so firms cannot charge users and the market under‑produces.
Merit goods – arise because consumers undervalue the social benefits, leading to under‑consumption.
De‑merit goods – arise because consumers undervalue the social costs, leading to over‑consumption.
Monopoly (market power) – arises when a single firm restricts output to maximise profit, resulting in a price above the competitive level.

5. Consequences of Market Failure (required four consequences plus others)

Type of Failure	Specific Consequence Required by the Syllabus	IGCSE‑style Example
Negative externality	Over‑production/over‑consumption (social cost > private cost)	Factory emits smoke, causing health problems for nearby residents.
Positive externality	Under‑production/under‑consumption (social benefit > private benefit)	Neighbour plants a tree that improves air quality for the whole street.
Public good	Non‑provision (free‑rider problem)	National defence would not be supplied by private firms.
Merit good	Under‑consumption (society loses potential benefits)	Too few children receive vaccinations.
De‑merit good	Over‑consumption (society bears extra costs)	High rates of smoking cause health‑care costs.
Monopoly (market power)	Higher‑than‑competitive price and lower output	Utility company charges above‑market rates because there is no competition.

6. Government Intervention – Instruments and Justification

In a mixed economy the government can use the following eight (plus quota) instruments. The table shows when each is used, a short justification, and an IGCSE‑style example.

Instrument	When It Is Used (type of failure)	Why It Works (justification)	IGCSE Example
Maximum (price ceiling)	To stop prices becoming too high (e.g., essential goods)	Restricts price below the market level, protecting consumers.	Rent control in a city with a housing shortage.
Minimum (price floor)	To keep prices from falling too low (e.g., agricultural products)	Sets price above the market level, guaranteeing a minimum income for producers.	Minimum wage for low‑paid workers.
Indirect tax	Negative externalities	Internalises the external cost by raising the private marginal cost to equal the social marginal cost.	Excise duty on cigarettes.
Subsidy	Positive externalities or merit goods	Lowers the private marginal cost (or raises private benefit) so that the market quantity moves toward the socially optimal level.	Government grant for solar‑panel installation.
Regulation	Negative externalities, health & safety concerns	Sets legal standards that limit harmful activity or require certain practices.	Emissions standards for cars.
Privatisation	Public monopoly where competition could improve efficiency	Transfers ownership to the private sector to introduce market discipline.	Sale of a state‑owned telecom company.
Nationalisation	Natural monopoly where private provision is inefficient	Brings the service under public control to ensure universal provision and price stability.	Government takes over water supply.
Direct provision	Public goods or merit goods that the market will not supply	The state produces or finances the good directly, removing the free‑rider problem.	State‑funded primary education.
Quota (quantity restriction)	De‑merit goods or imports that cause social harm	Limits the total amount that can be produced or imported, reducing over‑consumption.	Import quota on sugary drinks.

7. Diagram Checklist (what students must be able to draw and interpret)

Negative externality: supply curve (PMC) vs. social marginal cost (SMC) with the free‑market equilibrium (Q_m) to the right of the socially optimal equilibrium (Q_s).
Positive externality: demand curve (PMB) vs. social marginal benefit (SMB) with the free‑market equilibrium to the left of the socially optimal equilibrium.
Price ceiling (maximum): horizontal line below the competitive equilibrium price, showing resulting shortage.
Price floor (minimum): horizontal line above the competitive equilibrium price, showing resulting surplus.
Effect of an indirect tax on a negative externality: upward shift of the private supply curve, moving the market equilibrium toward the socially optimal point.
Effect of a subsidy on a merit good or positive externality: downward shift of the private supply curve (or upward shift of demand), moving equilibrium toward the socially optimal point.

8. Link to the Mixed Economic System

Modern economies are mixed: private firms operate in most markets, but the government intervenes where market failure would otherwise reduce overall welfare. The choice of instrument depends on the type of failure identified.

9. Suggested Diagrams for Presentation Slides

Negative externality: the social marginal cost (SMC) curve lies above the private marginal cost (PMC) curve, showing that the free‑market equilibrium quantity (Q_m) exceeds the socially optimal quantity (Q_s).

Price ceiling: a horizontal line set below the competitive price creates a shortage (Q_d > Q_s).

10. Key Points to Remember

Market failure = market outcome is not Pareto‑efficient.
The syllabus requires students to name four specific consequences:
- Over‑consumption of de‑merit goods
- Under‑consumption of merit goods
- Non‑provision of public goods
- Higher‑than‑competitive price and lower output under monopoly
Each cause of failure can be linked to a divergence between private and social marginal cost/benefit.
Government intervention is justified only when it can move the market toward the socially optimal outcome.
Identifying the type of failure determines the most appropriate policy tool and the diagram that must be drawn.

Definition of market failure