Causes of market failure relating to public goods, merit goods, demerit goods, external costs and external benefits, abuse of monopoly power

2.9 Market Failure – Allocation of Resources

2.9.1 Definition

Market failure occurs when the free market does not allocate resources efficiently, resulting in a loss of economic welfare (dead‑weight loss).

2.9.2 Key Terminology (syllabus wording)

2.9.3 Causes of Market Failure

2.9.3.1 Public Goods

• Features: non‑excludable & non‑rivalrous.
• Market outcome: free‑market provision is zero or far below the socially optimal level because firms cannot charge users.
• Government intervention:

  • Direct provision financed by taxation.
  • Public‑private partnerships where the state subsidises private provision.

2.9.3.2 Merit Goods

• Goods that generate positive externalities or are deemed socially desirable.
• Typical under‑consumption because private marginal benefit (PMB) < social marginal benefit (SMB) at the market equilibrium.
• Examples: education, vaccinations, public libraries, preventive health care.
• Policy tools:

  • Subsidies (lower price, shift demand right).
  • Free or heavily subsidised provision.
  • Compulsory consumption (e.g., school‑attendance laws).

2.9.3.3 Demerit Goods

• Goods that generate negative externalities or are socially undesirable.
• Typical over‑consumption because private marginal benefit (PMB) > social marginal benefit (SMB) at the market equilibrium.
• Examples: tobacco, alcohol, fast food, illegal drugs.
• Policy tools:

  • Excise (sin) taxes – raise price, shift demand left.
  • Regulation – age limits, licensing, advertising bans.
  • Public‑awareness campaigns.
  • Complete bans where the social cost is extremely high.

2.9.3.4 Externalities

2.9.3.4.1 Negative externalities (external costs)

• Production or consumption imposes costs on third parties that are not reflected in the market price.
• Result: over‑production/over‑consumption (Q_m > Q_s).
• Examples: factory pollution, noise from airports, traffic congestion.
• Policy responses:

  • Pigouvian (corrective) tax equal to the external cost per unit.
  • Regulation – quantity limits, technology standards.
  • Tradable permits/quotas (e.g., carbon trading).
  • Command‑and‑control (mandatory abatement).

2.9.3.4.2 Positive externalities (external benefits)

• Production or consumption confers benefits on third parties that are not captured in the market price.
• Result: under‑production/under‑consumption (Q_m < Q_s).
• Examples: research & development, education, immunisation, public parks.
• Policy responses:

  • Subsidies or grants that shift the private marginal cost downwards.
  • Public provision (e.g., free schooling, NHS immunisation programmes).
  • Tax incentives for private R&D (R&D tax credit).

2.9.3.5 Abuse of Monopoly Power

• A monopoly can restrict output and charge a price above marginal cost, creating allocative inefficiency and a dead‑weight loss.

2.9.3.5.1 Sources of monopoly power (2.9.5.1)

• Natural monopoly – high fixed costs and low marginal costs (e.g., water, electricity distribution).
• Government‑granted monopoly – licences, patents, copyrights.
• Strategic barriers – control of essential resources, aggressive pricing, product differentiation.

2.9.3.5.2 Government actions to curb monopoly power (2.9.5.2)

• Price caps or rate‑of‑return regulation.
• Breaking up the monopoly (e.g., liberalisation of telecoms).
• Encouraging competition – antitrust legislation, removing entry barriers.
• Public ownership of natural monopolies.

2.9.4 Consequences of Market Failure (2.9.4)

• Production/consumption occurs at a level where private marginal benefit ≠ social marginal benefit or private marginal cost ≠ social marginal cost.
• Resulting dead‑weight loss represents a loss of total (consumer + producer) surplus.
• Allocative inefficiency: resources are not used where they generate the greatest net benefit to society.

2.9.6 Summary Table of Market Failure Types

2.9.7 Key Points to Remember for the Exam

1. Market failure justifies government intervention; the aim is to move the market outcome toward the socially optimal level.
2. Public goods are non‑excludable and non‑rivalrous, so the market cannot charge users – they require collective provision.
3. Merit goods are under‑consumed; demerit goods are over‑consumed. Use subsidies or free provision for merit goods, and taxes or regulation for demerit goods.
4. Externalities create a gap between private and social costs/benefits. Corrective taxes, subsidies, regulation, or tradable permits are the main tools.
5. Monopolies generate dead‑weight loss by producing less and charging more than in perfect competition. Price caps, rate‑of‑return regulation, breaking up the monopoly, or public ownership are common responses.
6. When answering exam questions, always:

   • Define the type of market failure using the exact syllabus wording.
   • Explain why the free market leads to an inefficient outcome (include the relevant diagram).
   • Identify at least two government interventions and evaluate their likely effectiveness (consider equity, efficiency, and practicality).