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Cambridge (CIE) IGCSE Your notes

Economics
2.10 Market Failure
Contents
Market Failure Terminology
Causes & Consequences
Government Intervention to Address Market Failure

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Market Failure Terminology

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Market Failure Defined
In a free market, the price mechanism determines the most efficient allocation of scarce resources in
response to the competing wants and needs in the marketplace
Scarce resources are the factors of production (land, labour, capital, enterprise)
Free markets often work very well
However, there is sometimes a less than optimum allocation of resources from the point of view of
society. This is called Market Failure
Sometimes there is an over-provision of goods/services which are harmful (demerit goods) and
therefore an over-allocation of the resources (factors of production) used to make these
goods/services e.g. cigarettes
Sometimes there is an under-provision of the goods/services which are beneficial (public goods
and merit goods) and therefore an under-allocation of the resources (factors of production) used
to make these goods/services e.g. schools
Sometimes the market causes a lack of equity (inequality) - the rich get richer and the poor get
relatively poorer
Sometimes, environmental damage occurs during the production or consumption of a
good/service
In each of these cases, from society’s point of view there is a lack of efficiency in the allocation of
resources

Private, Social and External Costs

Externalities occur when there is an external impact on a third party not involved in the economic
transaction between the buyer and seller
These impacts can be positive or negative and are often referred to as spillover effects
These impacts can be on the production side of the market (producer supply) or on the
consumption side of the market (consumer demand)
External costs occur when the social costs of an economic transaction are greater than the private
costs
A private cost for the producer, consumer or government is what they actually pay to produce or
consume a good/service e.g. a consumer pays $9 for a McDonald's meal

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An external cost is the damage not factored into the market transaction e.g. the consumer throws
their McDonalds packaging onto the street and the Government has to hire cleaners to collect the
litter Your notes
The social cost includes both the private cost and the cost to society
It is a better reflection of the true cost of an economic transaction
Social cost = private cost + external cost
Private, Social and External Benefits
External benefits occur when the social benefits of an economic transaction are greater than the
private benefits
A private benefit for a consumer, producer or government is what they actually gain from
producing or consuming a good/service e.g. a bee farm gains the private benefit of the income
from selling their honey
An external benefit (positive externality) is the benefit not factored in to the market transaction
e.g. The bees from the bee farm pollinate the nearby apple orchards
The social benefit includes both the private benefit and the external benefit to society
It is a better reflection of the true benefit of an economic transaction
Social benefit = private benefit + external benefit

Examiner Tip
Market failure results in the overconsumption of demerit goods and goods with external costs and
the underconsumption of merit goods and goods with external benefits. Your understanding of this
concept is frequently tested in MCQ.

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Causes & Consequences

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Causes and Consequences of Market Failure
Market Failure occurs when free market activity results in a less than optimum allocation of resources
from the point of view of society

The Causes and Consequences of Market Failure

Cause Explanation Consequences

Demerit These are goods which have harmful They are over-provided in a
Goods impacts on consumers/society market and their consumption
often creates external costs
They are often addictive
Governments often have to
E.g. Gambling, alcohol, drugs, sugary regulate these goods in such a way
foods/drinks that they raise the prices and/or
limit the quantities consumed

Merit Goods These are goods that are beneficial to They are under-provided in a
society but consumers under-consume market and their consumption
them as they do not fully recognise the generates both private and/or
private or external benefits external benefits
E.g. Vaccinations, education, electric cars Governments often have to
subsidise these goods in order to
lower the price and/or increase the
quantities consumed

Public Public goods are beneficial to society but Non-excludability refers to the
Goods would be under-provided by a free inability of private firms to exclude
market as there is little opportunity for certain customers from using their
sellers to make profits from providing products. In effect, the price
these goods/services as they are non- mechanism cannot be used to
excludable and non-rivalrous in exclude customers e.g. street
consumption lighting
Good examples include national defence, Non-rivalry refers to the inability of
parks, libraries and lighthouses the product to be used up, so there
is no competitive rivalry in

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consumption to drive up prices

and generate profits for firms
Therefore, governments will often Your notes
provide these beneficial goods
themselves, and so they are called
public goods

Abuse of The development of monopoly markets is The outcome is that

Monopoly a natural outcome of a market system goods/services are purposely
Power under-provided in order to raise
Firms seek to eliminate competition by prices and profits
buying out competitors and increasing
their ownership of factors of production Governments often intervene to
ensure that there is healthy
With less competition, firms can raise competition in markets and
prices, reduce the choice available to sufficient provision of
consumers, or limit the supply goods/services

Factor Factor immobility occurs when it is Factor immobility results an

Immobility difficult for factors of production to move inefficient allocation of resources
or switch between different in a market (usually under-
uses/locations provision)
The two main types of factor immobility Governments often implement
are the geographical and occupational programs to reduce the factor
immobility of labour immobility in order to raise
production and output

External Externalities occur when there is an A positive externality of

Costs and external cost or benefit on a third party consumption occurs when there is
Benefits not involved in the economic transaction a positive external benefit in
consumption, such as when
These impacts can be positive or negative electric vehicles are consumed
The price mechanism in a free market CO2 emissions fall
ignores these externalities A positive externality of
If these external costs/benefits were production occurs when there is a
acknowledged, then the price and output positive external benefit in
in the market would be different production, such as when
managed pine forests produce
timber but also increase CO2
absorption
A negative externality of
consumption occurs when there is

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an external cost in consumption

such as when the consumption of
alcohol increases anti social Your notes
behaviour
A negative externality of
production occurs when there is
an external cost in production such
as when the production of
electricity increases air pollution

Examiner Tip
When explaining externalities, your syllabus focusses on the external costs and benefits. It does not
specifically refer to negative/positive externalities of production or consumption. That language
has been included here as it helps to deepen your understanding which will help you to better
answer both MCQ and structured questions on market failure. You can use this economic language
knowing it will enhance your answers.

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Government Intervention to Address Market Failure

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Intervention to Address Market Failure
Four of the most commonly used methods to address market failure in markets are indirect taxation,
subsidies, maximum prices, & minimum prices
Additional methods of intervention include regulation, nationalisation, privatisation, & State provision
of public goods

Examiner Tip
The material on this page is frequently examined in the Paper 2 structured questions. You will be
asked to evaluate the effectiveness of taxes, subsidies, maximum & minimum prices. To do so:
1. Consider the advantages & disadvantages of each method of intervention
2. Explain that several methods of intervention are likely to be more effective than a single method
e.g. smoking is taxed & highly regulated (age restrictions, packaging restrictions, display
restrictions)
3. Consider different market segments and their responsiveness e.g. wealthy consumers will less
responsive (inelastic demand) to tax increases than poorer consumers (elastic demand)

Maximum Prices
A maximum price is set by the government below the existing free market equilibrium price and
sellers cannot legally sell the good/service at a higher price
Governments will often use maximum prices in order to help consumers. Sometimes they are used for
long periods of time e.g. housing rental markets. Other times they are short-term solutions to unusual
price increases e.g. petrol

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Your notes

The maximum price (Pmax) sits below the free market price (Pe) & creates a condition of excess
demand (shortage)

Diagram analysis
The initial market equilibrium is at PeQe
A maximum price is imposed at Pmax
The lower price reduces the incentive to supply and there is a contraction in QS from Qe → Qs
The lower price increases the incentive to consume and there is an extension in QD from Qe → Qd
This creates a condition of excess demand QsQd

The Advantages and Disadvantages of Using Maximum Prices

Advantages Disadvantages

Some consumers benefit as they Some consumers are unable to purchase due to the
purchase at lower prices shortage
They can stabilise markets in the short- The unmet demand usually encourages the creation
term during periods of intense of illegal markets (black/grey markets) as desperate

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disruption e.g. Covid supplies at the buyers turn to illegal bidding

start of the pandemic Maximum prices distort market forces and therefore
can result in an inefficient allocation of scarce Your notes
resources e.g. maximum prices in rentals in the
property market create a shortage

Minimum Prices
A minimum price is set by the government above the existing free market equilibrium price and sellers
cannot legally sell the good/service at a lower price
Governments will often use minimum prices in order to help producers or to decrease consumption
of a demerit good e.g. alcohol

The imposition of a minimum price (Pmin) above the free market price (Pe) creates a condition of excess
supply (surplus)

Diagram analysis
The initial market equilibrium is at PeQe
A minimum price is imposed at Pmin
The higher price increases the incentive to supply & there is an extension in QS from Qe → Qs
The higher price decreases the incentive to consume & there is a contraction in QD from Qe → Qd
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This creates a condition of excess supply QdQs

The Advantages & Disadvantages of Using Minimum Prices in Product Markets Your notes

Advantages Disadvantages

In agricultural markets, producers benefit as they It costs the government to purchase

receive a higher price (Governments will often purchase the excess supply & an opportunity
the excess supply & store it or export it) cost is involved
When used in demerit markets, output Farmers may become over-
falls (Governments will not purchase the excess supply dependent on the Government's
of a demerit good) help
Producers usually lower their output in the market to Producers lower output which may
match the QD at the minimum price & this helps to result in an increase in
reduce the external costs unemployment in the industry

Minimum prices in labour markets

Minimum prices are also used in the labour market to protect workers from wage exploitation
These are called national minimum wages
A national minimum wage (NMW) is a legally imposed wage level that employers must pay their
workers
It is set above the market rate
The minimum wage/hour varies based on age

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Your notes

A national minimum wage (NMW1) is imposed above the market wage rate (We) at W1

Diagram analysis
The demand for labour (DL) represents the demand for workers by firms
The supply of labour (SL) represents the supply of labour by workers
The market equilibrium wage & quantity for truck drivers in the UK is seen at WeQe
The UK government imposes a national minimum wage (NMW) at W1
Incentivised by higher wages, the supply of labour increases from Qe to Qs
Facing higher production costs, the demand for labour by firms decreases from Qe to Qd
This means that at a wage rate of W1 there is excess supply of labour & the potential for
unemployment equal to QdQs
The Advantages and Disadvantages of a Minimum Wage in Labour Markets

Advantages Disadvantages

Guarantees a minimum income Raises the costs of production for firms who may respond
for the lowest paid workers by raising the price of goods/services

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Higher income levels help to If firms are unable to raise their prices, the introduction of a
increase consumption in the minimum wage may force them to lay off some workers
economy (increase unemployment) Your notes
May incentivise workers to be
more productive

Indirect Taxation
An indirect tax is paid on the consumption of goods/services
It is only paid if consumers make a purchase
It is usually levied by the government on demerit goods to reduce the quantity demanded (QD)
and/or to raise government revenue
Government revenue is used to fund government provision of goods/services e.g education
Indirect taxes are levied by the government on producers. This is why the supply curve shifts
Producers and consumers each pay a share (incidence) of the tax

The impact of an indirect tax is split between the consumer (A) & the producer (B)

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Diagram analysis
The government places a specific tax on a demerit good Your notes
The supply curve shifts left from S1→S2 by the amount of the tax
The price the consumer pays has increased from P1 before the tax, to P2 after the tax
The price the producer receives has decreased from P1 before the tax to P3 after the tax
The government receives tax revenue = (P2-P3) x Q2
The consumer incidence (share) of the tax is equal to area A: (P2-P1) x Q2
The producer incidence (share) of the tax is equal to area B: (P1-P3) x Q2
The QD in this market has decreased from Q1→Q2
If the decrease in QD is significant enough, it may force producers to lay off some workers

The Advantages & Disadvantages of Indirect Taxes

Advantages Disadvantages

Reduces the quantity The effectiveness of the tax in reducing the use of demerit
demanded of demerit goods goods depends on the price elasticity of demand (PED)
Raises revenue for Many consumers who purchase products that are price
government programs inelastic in demand will continue to do so
It may help create illegal markets as consumers seek to avoid
paying the taxes
Producers may be forced to lay off some workers as output
falls due to the higher prices

Examiner Tip
This further develops the exam tip mentioned above. When analysing the impact of taxes on a
market it is worth highlighting the elasticity of the product as it influences who pays more of the tax
(producer or consumer).

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The more price inelastic the product, the greater the proportion of the tax will be passed on to
consumers by producers as the QD will fall less proportionately than the price increase. The more
price elastic the product, the smaller the proportion of the tax will be passed on to consumers by Your notes
producers as the QD will fall more proportionately than the price increase. (See sub-topic 2.7.2 for
more on PED)

Producer Subsidies
A producer subsidy is a per unit amount of money given to a firm by the government
To increase production
To increase the provision of a merit good
The way a subsidy is shared between producers & consumers is determined by the price elasticity of
demand (PED) of the product
Producers keep some of the subsidy & pass the rest on to the consumers in the form of lower
prices

A diagram which demonstrates the cost of a subsidy to the government (A+B) and the share received by
the consumer (A) & producer (B)

Diagram analysis
The original equilibrium is at P1Q1
The subsidy shifts the supply curve from S → S + subsidy:

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This increases the QD in the market from Q1→Q2

The new market equilibrium is P2Q2 Your notes
This is a lower price and higher QD in the market
Producers receive P2 from the consumer PLUS the subsidy per unit from the government
Producer revenue is therefore P3 x Q2
Producer share of the subsidy is marked B in the diagram
The subsidy decreases the price that consumers pay from P1 → P2
Consumer share of the subsidy is marked A in the diagram
The total cost to the government of the subsidy is (P3 - P2) x Q2 represented by area A+B

The Advantages & Disadvantages of Producer Subsidies

Advantages Disadvantages

Can be targeted to helping specific industries Distorts the allocation of resources in markets
e.g. it often results in excess supply when used
Lowers prices & increases demand for merit in agricultural markets
goods
There is an opportunity cost associated with
Helps to change destructive consumer the government expenditure - could the
behaviour over a longer period of time e.g. money have been better used elsewhere?
subsidising electric cars makes them
affordable and helps motorists to see them as Subsidies are prone to political pressure &
an option for the masses - & not just the elite lobbying by powerful business interests e.g.
most oil companies receive subsidies from
their respective governments (despite making
$billions in profits each year)

Other Government Policy Measures to Address Market

Failure
Other Methods Used To Address Market Failure

Method Explanation Advantages Disadvantages

State Provision Public goods are beneficial They are usually Paid for through
of Public for society & are not provided free at the general taxation

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Goods provided by private firms point of There is an

due to the free rider consumption opportunity cost
problem Accessible to associated with Your notes
Examples include roads, everyone regardless their provision
parks, lighthouses, national of income
defence Products which are
Usually provide both free may result in
private & external excess demand &
benefits to society long waiting times
e.g. procedures at
Public hospitals

Privatisation Privatisation occurs when Increases Government

governments transfer government assets are often
ownership & control of revenue in the year sold well below
firms/assets from the State the asset is sold their actual
(public sector) to the market value
private sector (private Private firms may run
firms) the business more Private firms often
efficiently provide a sub
Many State firms are standard
monopolies. By privatising The government no good/service as
them it encourages more longer needs to they cut quality to
competition in those manage the business increase profits
markets or hire people to
work for it - this The price of the
This should result in more reduces good/service
efficiency & lower prices government usually increases
for consumers expenditure as firms seek to
maximise their
profit e.g. energy
prices in the UK
market
Many privatised
companies still
maintain
considerable
market power &
have to be
regulated, e.g.
water companies

Nationalisation Nationalisation occurs This can generate Government firms

when the Government efficiencies, can often run very

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takes control & ownership especially when inefficiently

of firms which were in the delivering utilities There is an
private sector (gas, water, opportunity cost Your notes
electricity) to the associated with
national population the money
It creates more required to run it
equity in society as
all citizens have the The Government
same access to the may lack the
same resource at the expertise to run
same price e.g. the business
Norway nationalised
much of the oil
industry when oil was
first discovered in
1972. The profits
belong to the
citizens
The business can
generate significant
revenue for
government

Regulation Governments create rules Individuals or firms Enforcing laws

to limit harm from the may be requires the
external costs of fined/imprisoned government to hire
consumption/production for breaking the rules more people to
e.g. selling work for the
They often create cigarettes to minors regulatory
regulatory agencies to is a punishable agencies
monitor that the rules are offence
not broken Enforcing laws can
They help to reduce be difficult as it is a
the external costs of complex process
demerit goods to determine if
firms/consumers
Fines can generate are breaking the
extra government laws
revenue
The regulation may
create
underground
(illegal) markets
which could

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generate even
higher external
costs on society Your notes

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