Understanding the terminology used to describe market failure is essential for analysing why markets sometimes do not allocate resources efficiently.
Public goods: Goods that are non‑excludable and non‑rivalrous. Once provided, no one can be excluded from using them and one person’s use does not diminish another’s.
Merit goods: Goods that provide benefits to individuals that exceed the value they place on them, leading to under‑consumption if left to the market.
Demerit goods: Goods that impose costs on consumers that exceed the perceived benefits, resulting in over‑consumption if left to the market.
Private benefits: The benefits received directly by the individual who consumes or produces a good.
External benefits (positive externalities): Benefits that accrue to third parties who are not directly involved in the transaction.
Social benefits: The total benefit to society, calculated as \$\text{Social Benefit}= \text{Private Benefit} + \text{External Benefit}\$.
Private costs: The costs incurred directly by the producer or consumer of a good.
External costs (negative externalities): Costs imposed on third parties who are not part of the transaction.
Social costs: The total cost to society, expressed as \$\text{Social Cost}= \text{Private Cost} + \text{External Cost}\$.
Monopoly: A market structure in which a single firm is the sole supplier of a product with no close substitutes, giving it market power to set price and output.
Comparison of Private vs. Social Outcomes
Concept
Private Perspective
Social Perspective
Benefit
Private Benefit
Social Benefit = Private Benefit + External Benefit
Cost
Private Cost
Social Cost = Private Cost + External Cost
Resulting Allocation
May be inefficient if externalities exist
Efficient allocation when social benefits = social costs (equilibrium)
Typical Market Failures Involving These Concepts
Under‑provision of public goods because firms cannot exclude non‑paying users.
Under‑consumption of merit goods (e.g., education, vaccinations) due to the gap between private and social benefits.
Over‑consumption of demerit goods (e.g., cigarettes, alcohol) because private benefits exceed private costs but not social costs.
Negative externalities such as pollution, where private costs are lower than social costs.
Positive externalities such as herd immunity, where private benefits are lower than social benefits.
Monopolistic markets that restrict output below the socially optimal level, creating a dead‑weight loss.
Suggested diagram: Supply and demand curves showing the divergence between private equilibrium (where private marginal benefit = private marginal cost) and social equilibrium (where social marginal benefit = social marginal cost). Highlight dead‑weight loss caused by a negative externality.