Market failure: externalities, public, merit and demerit goods

Last time

Before we start: last time, in Market equilibrium, shortages, surpluses and price changes, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

When markets get it wrong

A factory makes cheap cement and sells it at a profit, but its smoke makes people nearby ill. The market has produced the cement, but it has ignored a cost. When a market allocates resources inefficiently like this, we call it market failure.

What market failure means

Market failure is when the market forces of demand and supply fail to allocate resources efficiently. Too much or too little of a product is made. The examiner warned that it is sometimes confused with a firm failing to make a profit. That is not market failure. Its causes are externalities, public goods, merit and demerit goods, monopoly power, and immobile resources.

Private, external and social

Private costs are paid by the producer or consumer themselves, such as a firm's wages and raw materials. External costs and benefits fall on third parties, people who are not involved in making or buying the product. Social cost is private cost plus external cost. Social benefit is private benefit plus external benefit.

External costs

When a factory pollutes a river, the people downstream pay with poorer health and dirtier water. They are not paid anything for it. Car drivers cause congestion and fumes that affect everyone else on the road. Because the firm ignores these costs, the product is too cheap and it is over-produced and over-consumed.

External benefits

When a person is vaccinated, they are protected, and so are the people around them, who are less likely to catch the disease. Education raises a worker's own income, a private benefit, and also makes the whole economy more productive. People only weigh their own private benefit, so these products are under-consumed.

Private and external, side by side

The examiner asked for the difference between a private benefit and an external benefit of healthcare. Here it is.

Public goods

A public good is non-excludable: once it is provided, people who do not pay cannot be stopped from using it. It is also non-rival: one person using it does not reduce what is left for others. Street lighting, defence and lighthouses are examples. So people wait for others to pay, the free-rider problem. Firms cannot earn revenue, so the market provides none. The government must.

Merit goods

A merit good is one that people under-value, so in a free market it is under-consumed. Education, healthcare and vaccinations are examples. People may lack information about its full benefits, and it has external benefits they ignore. Unlike a public good, a merit good can be charged for, and private schools and hospitals do provide it. The market just provides too little.

Demerit goods

A demerit good is one that people over-value, so it is over-consumed: cigarettes, alcohol and sugary drinks. People may not know, or ignore, how harmful it is to them, and it often has external costs, such as passive smoking. So governments discourage it, with taxes, age limits, advertising bans and health warnings.

Merit or public?

Cambridge often asks for the difference between a merit good and a public good, with an example of each. Use this table.

Fixing market failure

Provide public goods directly, paid for by taxes. Subsidise or provide merit goods to encourage consumption, and tax or ban demerit goods to discourage it. Regulate polluters, and give information campaigns. You will meet each tool in the next lesson.

Mistakes that lose marks

Mistake one: calling market failure the failure of a firm to make profit. Mistake two: saying a merit good cannot be provided by private firms. It can; there is just too little. Mistake three: in a government-action answer, saying 'a tax' without saying on what, and why. The fix: name the good, its type, the failure, and the specific action.

The full-marks tip

The full-marks tip: define each good by its feature: public goods are non-excludable and non-rival; merit goods are under-consumed; demerit goods over-consumed. Always give an example of each, and say who the third party is for an external cost.

On one card

So, on one card: market failure. Keep it for revision.