MARKET FAILURE UNIT

INTRODUCTION AND OVERVIEW

IB CORE CONCEPTS AND NOTES SPECIFICALLY RELATED TO THIS VIDEO

IB Core Concept Standard Level and High Level Concept

Market Failure • Define market failure
• Explain, and give examples, of merit goods, demerit goods, and
public goods.
• Define positive and negative externalities of production and
consumption.
• Examine the concept of market failure as a failure of the market to
achieve allocative efficiency, resulting in an over-allocation of
resources or an under-allocation of resources
• Define common access resources and sustainability.

Source: IB Economics Subject Guide

Overarching Idea: Market failure occurs when the price mechanism fails to deliver the optimal
and most efficient allocation of resources in a market, such that the best level of output for
society is reached. The market mechanism leads to the wrong level of output. If the market
mechanism, the forces of demand and supply, fail to produce the best level of output for society,
then community surplus is not maximized, and we say that this is a market failure. When
markets fail, governments are often expected to intervene and move towards the optimal
allocation of resources.

Types of Market Failure

1. Lack of public goods.
2. Undersupply of merit goods.
3. Over-supply of demerit goods.
4. The existence of externalities.

Market Failure 1: Lack of Public Goods

• Public goods are those that would not be provided at all in a free market.
• Since they are goods that are of benefit to society, the lack of public goods in a free
market is considered to be a market failure.
o Examples of public goods:
▪ National defense.
▪ Flood barriers.
• Two characteristics of public goods that prevent free markets from providing them:
o Non-excludable: impossible to stop other people from consuming it once it has
been provided.
o Non-rivalrous: when one person consuming it does not prevent another person
from consuming it as well.

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 o These characteristics make it pointless for private individuals to provide the
goods themselves.
• Government interventions to reduce this market failure:
1. They may provide the public good themselves. This is usually the case with
national defense, flood barriers, roads, pavements, street-lighting, lighthouses.
2. They may subsidize private firms, covering the costs, to provide the good.

Market Failure 2: Undersupply of Merit Good

• Merit goods are those underprovided by the market and, therefore, under-consumed.
• Government thinks they provide positive benefits for both: people that use them, and
for society as a whole. Therefore, these should be consumed to a greater degree.
• Examples of merit goods:
o Education.
o Health Care.
o Sports Facilities.
o Opera.
• Government intervention to reduce this market failure:
o Governments will attempt to increase the supply, and thus consumption of merit
goods.
o Intervention depends on how important they think the merit good is.
▪ If government thinks they are super important, then government will
provide them directly or will subsidize them. Even to no cost to the
consumer.
• Examples: Education and health care.
o As merit goods become less important in the eyes of the government, then they
will be subsidized, but to a lesser extent.
▪ Example: Sports facilities and the opera.

Market Failure 3: Over-supply of Demerit Good

• A demerit good is a good that the government thinks are bad both for people who
consume them and for society as a whole. Therefore, government would like to see
them consumed to a lesser degree or not all.
• Examples of demerit goods:
o Cigarettes.
o Alcohol.
o Hard Drugs.
o Child Pornography.
• Government intervention to reduce this market failure:
o Governments may attempt to reduce the supply and/or demand for demerit
goods.
o Intervention depends on how harmful they think the good is.
▪ In extreme cases—hard drugs and child pornography—the government
will make them illegal.

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 ▪ Of course, they don’t disappear, a black market is created.
▪ As demerit goods become less harmful in the eyes of the government,
they will be taxed.

Market Failure 4: The Existence of Externalities (Positive and Negative)

• An externality occurs when the production or consumption of a good or service has an
effect upon a third party.
• If the effect is harmful, then we talk about a negative externality.
o This results in an external cost that must be added to the private costs of the
producer or consumer to reflect the full cost to society.
• If the effect is beneficial, then we talk about a positive externality.
o There has been an external benefit to society to add to the private benefits of
the producer or consumer
• Important Background Information: Community surplus graph with MSC and MSB

• Marginal Social Cost (MSC)

o We have already come across marginal social cost (MSC).
o MSC is equal to marginal private cost (MSC) plus or minus any external cost or
benefit of production.
o If there are no externalities of production then MSC = MPC.
o The MPC is essentially the “private” supply curve that is based on the firm’s cost
of production.
• Marginal Social Benefit (MSB)
o MSB is equal to marginal private benefit (MPB) plus or minus any external cost
or benefit of consumption.
o If there are no externalities of consumption then MSB = MPB
o The MPB is essentially the “private” demand curve that is based on the utility or
benefits to consumers.
• If no externalities exist, then MSC = MSB and we have social efficiency and so
maximum community surplus.
• If externalities do exist, then MSC does not equal MSB and so we have market failure
and an inefficient allocation of resources.

• To Conclude:
o A free market leads to allocative efficiency.
o Community surplus is maximized.
o So, it is the optimum allocation of resources from society’s point of view.

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 o This occurs when demand is equal to supply, or, when marginal social benefit is
equal to marginal social cost, the equilibrium point.
o If not, we have market failure.

• Externalities may be split into four types

1. Negative externalities of production/external costs.
2. Positive externalities of production/external benefits.
3. Negative externalities of consumption.
4. Positive externalities of consumption.

Source: Jocelyn Blink and Ian Dorton. IB Economics: Course Companion, Second Edition.