Market failure and government intervention
Markets can fail to allocate resources efficiently because of externalities, merit and demerit goods, public goods and monopoly. Governments in mixed economies intervene to correct this.
📌 Key points
- In a market economic system most resources are privately owned and allocated by the price mechanism; it gives choice and incentives to be efficient but can lead to market failure and inequality.
- Market failure happens when the price mechanism allocates resources inefficiently, so too much or too little of a product is made.
- Private costs + external costs = social costs; private benefits + external benefits = social benefits.
- An externality is a cost or benefit to a third party; markets over-produce products with external costs (e.g. pollution) and under-produce those with external benefits.
- Merit goods (e.g. education, vaccinations) are more beneficial than people realise, so they are under-consumed; demerit goods (e.g. cigarettes) are more harmful than people realise, so they are over-consumed.
- Public goods (e.g. street lighting, national defence) are non-excludable and non-rival, so the free-rider problem means private firms will not supply them.
- In a mixed economic system resources are allocated by both the private sector and the public sector.
- A maximum price set below equilibrium makes a product cheaper but creates a shortage; a minimum price set above equilibrium creates a surplus.
- Governments can also use indirect taxes (shift supply left), subsidies (shift supply right), regulation, direct provision, privatisation and nationalisation.
📖 Key terms
- Market failure
- When the market mechanism leads to an inefficient allocation of resources.
- Externality
- A cost or benefit that affects a third party not directly involved in the transaction.
- Social cost
- The total cost to society of an activity: private costs plus external costs.
- Merit good
- A product that is more beneficial than consumers realise and is under-consumed in a free market.
- Demerit good
- A product that is more harmful than consumers realise and is over-consumed in a free market.
- Public good
- A product that is non-excludable and non-rival, e.g. street lighting.
- Free rider
- Someone who benefits from a product without paying for it.
- Maximum price
- A legal limit on how high a price can be set.
✏️ Worked example
A factory’s private costs are $50,000 a year. Its smoke causes $20,000 of health and cleaning costs to local residents. Calculate the social cost and explain why the market fails.
- Private cost (paid by the factory) = $50,000.
- External cost (paid by third parties, the residents) = $20,000.
- Social cost = private cost + external cost = $50,000 + $20,000 = $70,000.
- The factory ignores the $20,000 external cost when deciding how much to produce.
- Answer: social cost = $70,000; the good is over-produced, so the market fails.
When you name an externality, say who the third party is and what the cost or benefit is. ‘Pollution is bad’ earns little; ‘smoke damages the health of local residents’ earns marks.
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