Market Failure Terminology (Cambridge (CIE) O Level Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
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
Examiner Tips and Tricks
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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