What market failure means
Market failure occurs when the price mechanism leads to a misallocation of resources, so that too much or too little of a good is produced compared with what is best for society. Even well-functioning markets can fail in this way.
Key idea
Social cost = private cost + external cost. When decisions ignore external costs and benefits, the market outcome differs from the socially efficient outcome.
Externalities
An external cost (negative externality) is a cost paid by third parties not involved in the transaction, such as pollution from a factory. An external benefit (positive externality) is a benefit gained by third parties, such as fewer illnesses when people are vaccinated. Goods with external costs tend to be over-produced; goods with external benefits tend to be under-produced.
Example
A factory that dumps waste into a river lowers its own costs but harms fishing communities downstream. The pollution is an external cost, so the market over-produces the good.
Merit, demerit and public goods
- Merit goods (such as education) are under-consumed because people undervalue their benefits.
- Demerit goods (such as cigarettes) are over-consumed because people ignore their harm.
- Public goods (such as street lighting) are non-excludable and non-rival, so private firms will not supply them because of the free-rider problem.
Remember
- Negative externalities lead to over-production.
- Positive externalities lead to under-production.
- Governments may tax, subsidise, regulate or provide goods to correct market failure.