Market failure | IGCSE Class 10 Economics Notes

This note covers market failure for IGCSE Economics: the definition of market failure, the key terms (public good, merit good, demerit good, private and social costs and benefits), the causes of market failure (public goods, merit and demerit goods, external costs and benefits, abuse of monopoly power, factor immobility), and the consequences of market failure (over-consumption of demerit goods and goods with external costs, under-consumption of merit goods and goods with external benefits).

What is market failure?

What does market failure mean?

Market failure occurs when the free market, left to itself, fails to allocate scarce resources efficiently.

In a perfectly working market, resources go to where consumers value them most, so the price mechanism allocates goods and services in a way that maximises total welfare.

Market failure means this does not happen: either too much or too little of a good or service is produced and consumed, so there is a misallocation of resources.

Key terms: public, merit and demerit goods

Several key terms are used to explain why markets fail. A public good is a good that is non-excludable and non-rival, so the free market tends not to provide it at all.

A merit good is a good that creates positive externalities and is under-consumed if left to the free market, often because consumers underestimate its benefits.

A demerit good is a good that creates negative externalities and is over-consumed if left to the free market, often because consumers underestimate its harms.

Private and social costs and benefits

Market failure is also explained using the ideas of private and social costs and benefits.

Private costs and private benefits are the costs and benefits that fall on the individual firm or consumer directly involved in producing or consuming a good.

Social costs and social benefits are the total costs and benefits to society as a whole, including effects on third parties who are not part of the transaction.

When private and social costs or benefits diverge, the free market produces an outcome that does not maximise society's welfare, which is the essence of market failure.

What are public goods?

A public good has two defining characteristics. It is non-excludable, meaning that once it is provided, no one can be stopped from consuming it, even if they have not paid for it.

It is also non-rival, meaning that one person's consumption of the good does not reduce the amount available for anyone else to consume.

Street lighting, national defence and flood barriers are often used as examples of public goods, because it is impractical to charge individual users and one person benefiting does not use up the benefit for others.

Because a public good is non-excludable, a private firm cannot easily charge a price for it, since people cannot be prevented from using it whether they pay or not.

This creates the free-rider problem: individuals can enjoy the benefit of the good without contributing to its cost, because they cannot be excluded from consuming it.

If everyone reasons this way, no one has an incentive to pay, so a profit-seeking private firm has no incentive to supply the good at all.

The free market therefore fails to provide public goods, even though society as a whole may value them highly. This is why public goods are usually provided or funded by government rather than by private firms responding to market signals.

What are merit goods and demerit goods?

A merit good is a good or service that generates external benefits, meaning that its consumption benefits people other than the direct consumer.

Education and healthcare are commonly used as examples of merit goods, because an educated or healthy population benefits the wider economy and society, not just the individual who is educated or treated.

Left to the free market, merit goods tend to be under-consumed, because individual consumers base their decisions only on the private benefit to themselves and often underestimate or ignore the wider benefit to society, so market demand is lower than the socially desirable level.

A demerit good is a good or service that generates external costs, meaning that its consumption harms people other than the direct consumer.

Tobacco and alcohol are commonly used as examples of demerit goods, because their consumption can harm the health of the consumer and impose costs on others, for example through passive smoking or on healthcare systems.

Left to the free market, demerit goods tend to be over-consumed, because consumers again base their decisions mainly on private benefit and private cost, often underestimating the harm to themselves and ignoring the cost imposed on third parties, so market demand and output are higher than is socially desirable.

What are external costs and external benefits?

Negative externalities and external costs

An externality is a cost or benefit experienced by a third party who is not directly involved in the production or consumption decision.

Externalities are central to explaining market failure because the price mechanism only reflects private costs and private benefits; it does not automatically include the costs or benefits imposed on others.

A negative externality, or external cost, arises when production or consumption harms a third party, for example when a factory's pollution damages the health of nearby residents or when a noisy nightclub disturbs local households.

In this case, the social cost of the activity (private cost plus external cost) is greater than the private cost alone, so the free market tends to produce more of the good than is socially desirable.

Road traffic congestion is another commonly used example of a negative externality: each additional driver adds to journey times and pollution for every other road user, a cost the driver does not pay directly and so does not take into account when deciding whether to make the journey.

Positive externalities and external benefits

A positive externality, or external benefit, arises when production or consumption benefits a third party, for example when a vaccinated individual reduces the risk of disease spreading to others, or when a well-trained worker raises the productivity of colleagues.

Here, the social benefit of the activity (private benefit plus external benefit) is greater than the private benefit alone, so the free market tends to produce less of the good than is socially desirable.

Because decision-makers in a free market generally respond only to the private costs and private benefits they themselves face, any divergence between private and social values signals that the free-market quantity will differ from the quantity that would maximise society's welfare; this divergence is the underlying reason why externalities are treated as a cause of market failure, whether the externality arises in production, as with a polluting factory, or in consumption, as with a demerit good.

How does abuse of monopoly power cause market failure?

How monopoly power restricts output and price

A monopoly exists when a single firm, or a small group of firms acting together, dominates a market and faces little or no competition.

Monopoly power gives a firm the ability to restrict output and charge a higher price than would exist under competition, because consumers have few or no alternative suppliers to turn to.

When a firm abuses its monopoly power, it can choose to produce less than the socially efficient quantity of output while charging a higher price, earning higher profits at the expense of consumers.

A monopolist may also use its market power in ways that keep potential competitors out, for example by setting prices so low in the short run that a new rival cannot survive, before raising prices again once the threat has gone; this is sometimes described as predatory behaviour, and it reinforces the firm's ability to restrict output and raise price over the longer term without fear of new entry.

Consumer effects of monopoly power

This is a form of market failure because resources are not being allocated according to consumer wishes expressed through competitive prices; instead, output is restricted below the level that would exist in a more competitive market, and consumers may also have less choice and lower quality than they would under competition.

The misallocation arises because the monopolist's private interest in maximising its own profit does not coincide with the interest of society in having output at the competitive, cost-reflective level.

A monopolist facing no close competitors also has a weaker incentive to innovate or to keep costs down, since customers have nowhere else to turn even if quality is poor or prices rise, so inefficiency inside the firm itself can persist without being disciplined by rival firms competing for the same customers.

The consumer effects of monopoly power can therefore be summarised as higher price, lower output, less choice and, often, a lower incentive for the firm to improve the product, all of which point to resources not being used in the way that would best satisfy consumer wants if the market were more competitive.

Because a monopolist earns higher profit from restricting output than it would from producing at the competitive level, there is no automatic market force that pushes it back towards that level; unlike a firm in a competitive market, which loses customers to rivals if it tries to charge too much, the monopolist's customers have nowhere else to go, so the misallocation of resources caused by abuse of monopoly power can persist for as long as the firm's dominant position remains unchallenged.

How does factor immobility cause market failure?

Occupational and geographical immobility

Factor immobility refers to the inability of factors of production, especially labour and capital, to move easily from one use, industry or location to another.

When resources cannot move freely to where they are most needed, the free market cannot reallocate them efficiently, which is itself a form of market failure.

Occupational immobility occurs when workers cannot easily move between different types of jobs, often because they lack the necessary skills, qualifications or training, or because retraining is costly and time-consuming.

Geographical immobility occurs when workers cannot easily move between different locations to take up work, for example because of the cost of moving house, family and social ties, or differences in the cost of living between regions.

Capital can also be immobile: specialist machinery built for one industry, such as equipment designed only for mining or for a particular type of manufacturing, often cannot be converted cheaply to another use, so when demand for that industry's output falls, the capital tied up in it may sit idle rather than moving to a more productive use elsewhere.

Consequences of factor immobility

Because of factor immobility, some industries and regions may suffer high unemployment and have unused resources at the same time that other industries and regions face shortages of labour or capital.

The price mechanism alone cannot solve this quickly, because wages and returns to capital may not adjust fast enough, or workers may be unwilling or unable to respond to these price signals by moving.

This mismatch between where resources are and where they are needed is a further source of market failure, since the free market, left alone, does not automatically retrain workers or convert specialist capital, so the gap between idle resources in a declining industry or region and unfilled vacancies elsewhere can last for a considerable time.

What is the misallocation of resources caused by market failure?

The causes of market failure described above lead to a common consequence: a misallocation of resources, meaning that resources are not being used in the way that would best satisfy society's wants. This misallocation shows up differently depending on the type of good involved.

Under-consumption of goods with external benefits

For goods and services with external benefits, including merit goods, the consequence of market failure is under-consumption and under-production relative to the socially desirable level.

Because the free market only reflects private benefit, fewer resources are devoted to these goods than society would wish, so society loses out on the wider benefits that greater consumption would have brought, for example better public health or a more skilled workforce.

Over-consumption of goods with external costs

For goods and services with external costs, including demerit goods, the consequence of market failure is over-consumption and over-production relative to the socially desirable level.

Because the free market only reflects private cost, more resources are devoted to these goods than is socially desirable, so society bears costs, such as pollution or health damage, that are not reflected in the price paid by the consumer.

In both cases, the market quantity settles where private benefit equals private cost, rather than where social benefit equals social cost, so the free-market outcome is not the quantity that would maximise welfare for society as a whole; this gap between the private outcome and the socially efficient outcome is what economists mean by a misallocation of resources, and it is the single idea that links every cause of market failure examined in this topic, from public goods and externalities to monopoly power and factor immobility.

What are the wider consequences of market failure?

Effects on specific markets

Beyond the specific over- or under-consumption of particular goods, market failure means that the economy as a whole does not achieve the most efficient use of its scarce resources.

Where public goods would not be provided at all by the free market, society would be deprived of goods it values, such as defence or street lighting, unless government steps in.

Where monopoly power is abused, consumers pay higher prices and receive a smaller quantity of output and less choice than they would under more competitive conditions.

Where factor immobility persists, some regions and industries experience persistent unemployment of labour and capital at the same time that other areas face shortages, so total output in the economy is lower than it could be if resources moved freely to their most valued uses.

Effects on the economy as a whole

Taken together, these consequences mean that market failure reduces the overall welfare of society compared with what would be achieved if resources were allocated efficiently; this is why market failure is treated as a key reason why many economies rely on some combination of market forces and government action rather than the free market alone.

Each cause of market failure examined in this topic, public goods, merit and demerit goods, external costs and benefits, abuse of monopoly power and factor immobility, can be present in an economy at the same time, so the overall loss of welfare from market failure is usually the combined result of several of these causes acting together rather than any single cause alone.

Recognising which cause is at work in a given situation, and whether the resulting consequence is over-consumption, under-consumption, non-provision, restricted output or persistent unemployment, is therefore the key skill needed to analyse market failure in an unfamiliar context.

Going beyond the syllabus

Although diagrams showing demand and supply for cases of market failure are not required at this level, it can help understanding to picture, in general terms, how private and social costs or benefits can diverge, since this is the underlying idea behind every cause of market failure discussed above.

On a diagram with quantity on the horizontal axis and cost or price on the vertical axis, a marginal private cost curve and a marginal social cost curve are drawn, with the social cost curve lying above the private cost curve by the amount of the external cost at each quantity.

The free-market equilibrium, determined where private cost meets demand, lies to the right of the socially efficient quantity, where social cost would meet demand, illustrating over-production of a good with external costs such as a demerit good.

On a diagram with quantity on the horizontal axis and benefit or price on the vertical axis, a marginal private benefit curve and a marginal social benefit curve are drawn, with the social benefit curve lying above the private benefit curve by the amount of the external benefit at each quantity.

The free-market equilibrium, determined where private benefit meets supply, lies to the left of the socially efficient quantity, where social benefit would meet supply, illustrating under-production of a good with external benefits such as a merit good.

These diagrams are not examined for this unit; they are included only to make the gap between private and social outcomes easier to visualise, since the examined content is confined to the definitions, causes and consequences described above.

What is a quick summary of the causes and consequences of market failure?

The causes of market failure described above each lead to a particular consequence for how resources are allocated. The table below brings these together in one place, matching each cause to a typical example and the consequence that follows when the free market is left alone.

Reading across each row shows the same pattern: a market feature, such as non-excludability, an externality or restricted competition, stops the free market from reaching the quantity of output that would maximise society's welfare. The result is always some form of misallocation of resources, whether that is a good not being supplied at all, being supplied in the wrong quantity, or being supplied at the wrong price.

This table is a useful checklist when answering a question on market failure, since many exam questions describe a real-world situation and ask which cause is at work and what consequence follows from it.

Glossary

• Market failure — a situation in which the free market fails to allocate scarce resources efficiently, so welfare is not maximised.
• Public good — a good that is non-excludable and non-rival, which the free market tends not to provide.
• Merit good — a good that creates external benefits and is under-consumed if left to the free market.
• Demerit good — a good that creates external costs and is over-consumed if left to the free market.
• Non-excludability — the characteristic of a good whereby no one can be prevented from consuming it once it is provided.
• Non-rivalry — the characteristic of a good whereby one person's consumption does not reduce the amount available to others.
• Free-rider problem — the situation in which people can benefit from a good without paying for it, because they cannot be excluded from consuming it.
• Externality — a cost or benefit of an economic activity that falls on a third party not directly involved in the transaction.
• External cost — a cost of production or consumption imposed on a third party, not reflected in the market price.
• External benefit — a benefit of production or consumption received by a third party, not reflected in the market price.
• Private cost — the cost borne directly by the firm or individual carrying out the activity.
• Private benefit — the benefit received directly by the firm or individual carrying out the activity.
• Social cost — the total cost to society of an activity, equal to private cost plus external cost.
• Social benefit — the total benefit to society of an activity, equal to private benefit plus external benefit.
• Monopoly power — the ability of a firm with little or no competition to restrict output and raise price above the competitive level.
• Factor immobility — the inability of factors of production to move easily between uses, industries or locations.
• Occupational immobility — the inability of workers to move between different types of jobs, often due to a lack of skills.
• Geographical immobility — the inability of workers to move between locations to take up work.
• Misallocation of resources — a pattern of resource use that does not maximise society's welfare, too much here, too little there.

Common errors and misconceptions

• Misconception: market failure means that no market exists at all. Correct: market failure means the market exists but does not allocate resources efficiently, often over- or under-producing a good.
• Misconception: a public good is simply any good provided by the government. Correct: a public good is defined by being non-excludable and non-rival; government provision is a response to this, not the definition itself.
• Misconception: merit goods and demerit goods are defined by whether the government likes them. Correct: they are defined by whether they create external benefits (merit) or external costs (demerit), which is why the free market under- or over-provides them.
• Misconception: private cost and social cost are always the same thing. Correct: social cost equals private cost plus any external cost; they are equal only when there is no externality.
• Misconception: external costs only affect the environment. Correct: external costs can affect health, noise levels, congestion and many other third-party effects, not only the natural environment.
• Misconception: monopoly power always causes market failure regardless of behaviour. Correct: it is the abuse of monopoly power, restricting output and raising price above the competitive level, that is identified as a cause of market failure.
• Misconception: factor immobility only means workers refusing to move. Correct: it also includes occupational immobility caused by a lack of skills or training, not only unwillingness to relocate geographically.

Exam-style questions with model answers

Q1. Define 'social cost'. [2 marks]

1. Social cost is the total cost to society of an activity, including costs borne by third parties.
2. It is equal to private cost plus any external cost, so social cost exceeds private cost whenever there is a negative externality.

Q2. Identify two characteristics of a public good. [2 marks]

1. A public good is non-excludable, so no one can be stopped from consuming it once it is provided, even without paying.
2. A public good is also non-rival, so one person's consumption does not reduce the amount available for others to consume.

Q3. A cigarette factory produces 500 000 packets of cigarettes a month. Smoking is known to damage the health of smokers and, through passive smoking, the health of others nearby. Explain two reasons why cigarettes are described as a demerit good. [4 marks]

1. Cigarettes impose an external cost on third parties, since passive smoking from the 500 000 packets produced each month can damage the health of people near a smoker, so the social cost of smoking to society is greater than the private cost paid by the smoker alone.
2. Smokers may also underestimate the harm to their own health, partly because of addiction, so they buy and smoke more than they would if they recognised the full private cost, meaning the free market leads to over-consumption of this demerit good relative to the socially desirable level.

Q4. A government report shows that a region has 40 000 unemployed factory workers at the same time that a growing technology industry in another region cannot fill 15 000 vacancies requiring specific digital skills. Explain two reasons why this situation might continue even though wages are rising in the technology industry. [4 marks]

1. The unemployed factory workers are likely to be occupationally immobile, since they lack the specific digital skills and qualifications the technology firms need, and retraining to gain these skills can be costly and take a long time, so they cannot quickly move into the vacant jobs even though wages there are rising.
2. Many of the workers may also be geographically immobile, unwilling or unable to move to the region with vacancies because of the cost of relocating, family and social ties, or a higher cost of living there, so higher wages in that region fail to attract enough of them to fill the vacancies.

Q5. Analyse how the abuse of monopoly power can cause market failure in a market for a good with no close substitutes. [6 marks]

1. A firm with monopoly power faces little or no competition, so it can restrict the quantity it supplies below the level that would exist in a competitive market, since consumers have no alternative supplier to switch to.
2. By restricting output, the firm can charge a higher price than the competitive price, increasing its own profit at the expense of consumers, who pay more and receive less than they would under competition.
3. Because output is below the competitive, socially efficient level, resources that could have been used to produce more of the good, benefiting consumers, are instead left unused or diverted elsewhere, which is a misallocation of resources.
4. Consumers facing a monopoly supplier may also have less choice and face lower incentives for the firm to innovate or improve quality, since the firm does not need to compete to retain customers, reinforcing the inefficient outcome.

Q6. Vaccination against a contagious disease costs $40 per person and is available through private clinics. Uptake of the vaccine among the eligible population is currently only 35%, well below the level doctors recommend to prevent the disease spreading. Analyse the consequences of this level of vaccination for society. [6 marks]

1. Vaccination creates an external benefit, since a vaccinated person is less likely to catch and spread the disease to others, so the social benefit of vaccination is greater than the private benefit received by the vaccinated individual alone.
2. Because individuals base their decision to pay the $40 fee mainly on the private benefit to themselves, and may underestimate or ignore the benefit to others, demand for vaccination in the free market is lower than the socially desirable level.
3. This leads to under-consumption of a good with external benefits, meaning fewer people are vaccinated than would maximise society's welfare, so the disease can continue to spread more widely than it would with higher uptake.
4. The wider population bears a cost from this under-consumption, for example through a greater risk of infection and pressure on healthcare services, which would have been reduced if vaccination had been consumed up to the socially efficient level.

Q7. A coastal town has no lighthouse because no private firm has been willing to build one, even though ships passing the coast would benefit from it. Explain why the free market fails to provide the lighthouse. [3 marks]

1. A lighthouse is non-excludable, since any ship sailing past at night benefits from its light whether or not its owner has paid, so a private firm cannot charge every ship that benefits.
2. Because non-paying ships cannot be excluded, individuals have an incentive to free-ride, so a profit-seeking firm has little financial incentive to build the lighthouse at all, and it may not be supplied unless government funds it.

Q8. Street lighting is non-excludable and non-rival. Discuss whether private firms could successfully provide street lighting to a town by charging each household a fee. [5 marks]

1. Street lighting is non-excludable, since once provided, no household in the area can be prevented from benefiting whether it pays the fee or not, so some households could refuse to pay and still enjoy the lit streets.
2. This creates a free-rider problem, where individuals have an incentive to avoid paying while still receiving the benefit, because a private firm has no practical way to exclude non-payers.
3. Street lighting is also non-rival, since one household benefiting does not reduce the light available to its neighbours, which weakens the case for charging a per-unit price.
4. If most households expect to free-ride, a private firm could not collect enough revenue to cover the cost of building and maintaining the lighting, so it has no incentive to supply it, meaning a fee-charging private system is unlikely to succeed.
5. A firm might still attempt to collect a fee if it is bundled with another excludable charge, such as a general household services bill, or if local government guarantees payment, but this makes the scheme closer to public provision than a true private market, so a purely private fee-charging system remains unlikely to succeed on its own.

Key takeaways

• Market failure happens when the free market fails to allocate resources efficiently, creating a misallocation of resources.
• A public good is non-excludable and non-rival, so the free-rider problem means the free market tends not to provide it.
• Merit goods create external benefits and are under-consumed by the free market; demerit goods create external costs and are over-consumed.
• Social cost equals private cost plus external cost; social benefit equals private benefit plus external benefit.
• Negative externalities mean social cost exceeds private cost, leading to over-production relative to the socially efficient level.
• Positive externalities mean social benefit exceeds private benefit, leading to under-production relative to the socially efficient level.
• Abuse of monopoly power restricts output and raises price above the competitive level, misallocating resources away from consumers.
• Factor immobility, occupational or geographical, stops labour and capital moving to where they are most needed, causing unemployment alongside shortages.
• The consequence of market failure for merit goods and goods with external benefits is under-consumption; for demerit goods and goods with external costs it is over-consumption.

Test yourself

What two characteristics define a public good?

A public good is non-excludable, so no one can be prevented from consuming it, and non-rival, so one person's consumption does not reduce the amount available to others.

Why does the free market tend to under-consume merit goods?

Consumers base decisions on private benefit alone and often underestimate the external benefit to society, so market demand is lower than the socially desirable level.

Why does the free market tend to over-consume demerit goods?

Consumers underestimate private harm to themselves and ignore the external cost imposed on others, so market demand and output exceed the socially desirable level.

What is the free-rider problem?

It is the situation where people can consume a non-excludable good without paying for it, because no one can be stopped from benefiting, removing the incentive for private firms to supply it.

How does social cost relate to private cost and external cost?

Social cost equals private cost plus external cost; when external cost is zero, social cost and private cost are the same.

Give one example of occupational immobility and one example of geographical immobility.

Occupational immobility: a worker cannot take a technology job because they lack digital skills. Geographical immobility: a worker cannot move to take a job because moving house is too costly.

How can the abuse of monopoly power misallocate resources?

A monopolist can restrict output below the competitive level and charge a higher price, so fewer resources are used to satisfy consumer demand than would be used under competition.