Market Failure Terminology (Cambridge (CIE) O Level Economics)

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

  • 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

• 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