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

Published by Patrick Mutisya · 14 days ago

IGCSE Economics 0455 – Market Failure

The Allocation of Resources – Market Failure

Market failure occurs when the free market does not allocate resources efficiently, leading to a loss of economic welfare. The following notes examine the main causes of market failure relevant to the Cambridge IGCSE Economics syllabus.

1. Public Goods

Public goods are characterised by two key features:

  • Non‑excludability: It is impossible or impractical to prevent anyone from using the good.

  • Non‑rivalry: One person’s consumption does not reduce the amount available for others.

Because firms cannot charge users directly, the private market under‑provides public goods. The government typically steps in to provide them.

Suggested diagram: Supply and demand for a public good showing under‑provision in the free market and the socially optimal level of provision.

2. Merit Goods

Merit goods are goods that generate positive externalities or are deemed socially desirable, leading to under‑consumption if left to the market.

  • Examples: Education, vaccinations, public libraries.

  • Government intervention: Subsidies, free provision, or compulsory consumption (e.g., school attendance).

3. Demerit Goods

Demerit goods are goods that generate negative externalities or are considered socially undesirable, leading to over‑consumption in a free market.

  • Examples: Tobacco, alcohol, illegal drugs.

  • Government intervention: Taxes, regulation, bans, or public awareness campaigns.

4. Externalities

4.1 External Costs (Negative Externalities)

When the production or consumption of a good imposes costs on third parties not reflected in the market price.

  • Examples: Pollution from factories, noise from airports.

  • Result: Over‑production relative to the socially optimal level.

Policy responses include: Pigouvian taxes, regulation, tradable permits.

4.2 External Benefits (Positive Externalities)

When the production or consumption of a good confers benefits on third parties that are not captured in the market price.

  • Examples: Research and development, education, immunisation.

  • Result: Under‑production relative to the socially optimal level.

Policy responses include: Subsidies, public provision, grants.

Suggested diagram: Marginal private cost (MPC) vs. marginal social cost (MSC) for a negative externality, showing the welfare loss (deadweight loss).

5. Abuse of Monopoly Power

A monopoly can restrict output and raise prices above the competitive equilibrium, creating a dead‑weight loss.

  • Sources of monopoly power: Natural monopolies, government‑granted licences, patents.

  • Consequences: Allocative inefficiency, reduced consumer surplus.

  • Government actions: Price caps, regulation, breaking up monopolies, encouraging competition.

Suggested diagram: Monopoly price and output compared with competitive equilibrium, illustrating dead‑weight loss.

6. Summary Table of Market Failure Types

Type of FailureKey CharacteristicTypical ExampleCommon Government Intervention
Public GoodsNon‑excludable & non‑rivalrousNational defence, street lightingDirect provision, funded by taxation
Merit GoodsUnder‑consumed; positive externalitiesEducation, vaccinationsSubsidies, free provision, compulsory attendance
Demerit GoodsOver‑consumed; negative externalitiesTobacco, alcoholExcise taxes, bans, age restrictions
Negative ExternalitiesExternal costs not reflected in priceFactory pollutionPigouvian tax, regulation, tradable permits
Positive ExternalitiesExternal benefits not reflected in priceResearch & developmentSubsidies, grants, public funding
Monopoly PowerMarket power leads to higher price, lower outputUtility companies, patented drugsPrice caps, regulation, competition policy

7. Key Points to Remember

  1. Market failure justifies government intervention to improve allocative efficiency.

  2. Public goods require collective provision because markets cannot supply them efficiently.

  3. Merit and demerit goods reflect societal judgments about what should be consumed.

  4. Externalities cause a divergence between private and social costs/benefits.

  5. Monopolies can create dead‑weight loss; regulation aims to mimic competitive outcomes.