Market Failure
— Economics · AS Level · Merit & Demerit Goods, Public Goods —
★ Starred on the board: definition of market failure, social cost & social benefit, factors affecting demand and supply, and the elastic vs inelastic tax cases (PED!!). Learn these word-for-word / shape-for-shape.
1. What is Market Failure?
★ DefinitionMarket failure occurs when a freely functioning market fails to allocate resources according to society's point of view, i.e. there is over- and under-allocation of resources, which results in welfare loss to society.
Society's point of view → efficient allocation of resources → no welfare loss.
Market failure ⇒ resources are not allocated efficiently ⇒ welfare loss.
| Type of good | Effect on society | Example | Result |
|---|---|---|---|
| Demerit good | harmful for society | cigarettes | over-allocation of resources |
| Merit good | beneficial for society | healthcare | under-allocation of resources |
2. Social Cost & Social Benefit
★ Social CostSocial Cost = Private Cost + External Cost
| Private Cost | External Cost | |
|---|---|---|
| Who bears it? | consumer + producer | 3rd party (no compensation paid) |
| What is it? | consumer → price of a good producer → cost of production | air pollution noise pollution passive smoking |
Definition: Social cost is the total cost to the society, which comprises of both private cost and external cost. Private cost is a cost borne by consumers and producers — for consumers it is the price of a good and for producers it is the cost of production. External cost is a cost borne by a third party for which no compensation is paid.
★ Social BenefitSocial Benefit = Private Benefit + External Benefit
| Private Benefit | External Benefit | |
|---|---|---|
| Who gets it? | consumer + producer | 3rd party |
| What is it? | consumer → satisfaction producer → revenue | employment |
Quick relation: Demerit good ⇒ SC > PC (external cost). Merit good ⇒ SB > PB (external benefit).
3. Factors Affecting Demand & Supply (★)
★ Factors affecting DEMAND
- Income
- Direct tax
- Prices of related goods
- Advertisement
- Changes in population
- Changes in consumer taste / patterns
★ Factors affecting SUPPLY
- Cost of production
- Technological advancement
- Subsidy
- Indirect tax
Link: The government policies below work by shifting these curves — indirect tax and subsidy shift supply; advertisement shifts demand.
4. Public Goods vs Private Goods
| Public Good | Private Good |
|---|---|
| Provided by public sector (government) | Provided by private sector (private producer) |
| Objective: social welfare | Objective: profit maximisation |
| Charged through taxes | Charged through the price mechanism |
| Eg: street lights | Eg: cake |
| Features: ① Non-rival ② Non-excludable ③ Non-rejectable ⇒ Free-rider problem | Features: ① Rival ② Excludable ③ Rejectable |
Definition: Public goods are goods provided by the public sector (government) with the objective of social welfare, and they charge through taxes.
- Non-rival — consumption by one individual will not reduce the consumption of another individual.
- Non-excludable — consumption by one individual will not exclude another individual from consuming it.
- Non-rejectable — it is not possible to reject these goods, as the government charges through taxes.
Free-rider problem: associated with non-excludability. The private sector will never provide these goods as there is no price mechanism to charge for them, so the entire responsibility is on the government, who provide them and charge through taxes. Consumers are aware: why pay for these goods if you can enjoy the benefits for free?
Note (board slip): the board paragraph says non-rival consumption "will reduce" another person's consumption — that is a slip. Non-rival means consumption does not reduce what is left for others (the table above has the correct meaning).
5. Demerit Goods
Remember: Demerit ⇒ SC > PC ⇒ overproduced, undercharged, overconsumed ⇒ welfare loss.
- Harmful for society
- External cost → negative externalities
- SC > PC
- Eg: drugs / alcohol / cigarettes
- Cause: lack of information / imperfections
- Over-produced → supply ↑
- Under-charged → price ↓
- Over-consumed → demand ↑
- Over-allocation of resources ⇒ welfare loss
Policies to deal with demerit goods
| Target (what we want) | Issue (the problem) |
|---|---|
| under-produced → supply ↓ | over-produced → supply ↑ |
| over-charged → price ↑ | under-charged → price ↓ |
| under-consumed → demand ↓ | over-consumed → demand ↑ |
① Indirect Tax (supply ↓)
e₁ – d: per-unit tax
Consumer burden: price P → P₁
Producer burden: below price P
Consumer burden: price P → P₁
Producer burden: below price P
- Tax on goods / services — eg G.S.T / V.A.T
- Cost ↑ → burden ↑ → demotivates producers
- Supply ↓ → shortage → price ↑ → QD ↓
- PED!! decides the effect (below)
C.Sbefore tax: P A eafter tax: P₁ A e₁C.S ↓
Tax revenue & PED ★Elastic: price ↑10%, QD ↓50%TR ↓ ⇒ tax revenue ↓, consumption ↓
| Demand | Price | QD | T.R. (firms) | Tax revenue | Consumption |
|---|---|---|---|---|---|
| ★ Elastic | ↑ 10% | ↓ 50% | ↓ | ↓ | ↓ |
| ★ Inelastic | ↑ 30% | ↓ 10% | ↑ | ↑ | ↓ |
Exam tip: if demand is inelastic, tax revenue ↑ but consumption still ↓. If elastic, QD falls proportionally more than price rises, so both T.R. and tax revenue ↓.
② Advertisement (demand ↓ — negative advertising)
- Advertisement = marketing, branding or promotion
- For demerit goods it is used to make demand ↓
- Informative adv — gives information, features of product, negative externalities. Eg: Smoking kills
- Persuasive adv — persuade, attract, use of celebrity. Eg: cinema
③ Complete Ban
- Pro: external cost eliminated
- Con: trade relations violated → retaliation
- Con: unemployment ↑ → unemployment benefits → opportunity cost
④ Minimum Price
Board note: the teacher wrote only the heading ④ Minimum Price next to the diagram and had not yet explained it on this page — nothing else was on the board for it.
6. Merit Goods
Remember: Merit ⇒ SB > PB ⇒ under-consumed (D↓), under-produced (S↓) ⇒ welfare loss.
- Beneficial for society
- Positive externalities → external benefit (3rd party)
- SB > PB
- Eg: healthcare / education
- Cause: lack of information → imperfections
- Under-consumed → demand ↓
- Under-produced → supply ↓
- Under-allocation of resources ⇒ welfare loss
Policies to deal with merit goods
| Target (what we want) | Issue (the problem) |
|---|---|
| over-consumed → demand ↑ | under-consumed → demand ↓ |
| over-produced → supply ↑ | under-produced → supply ↓ |
① Subsidy (supply ↑)
e₁ – d: per-unit subsidy
Consumer benefit: price P → P₁
Producer benefit: area above price P
Consumer benefit: price P → P₁
Producer benefit: area above price P
- Grant / cash payment from government → producer
- Cost ↓ → burden ↓ → motivates producers
- Supply ↑ → surplus → price ↓ → QD ↑
- PED!! decides how much QD rises
C.Sbefore: P A eafter: P₁ A e₁C.S ↑
P.Sbefore: P B eafter: P₁ C e₁P.S ↑
② Advertisement (demand ↑ — positive advertising)
- Marketing, branding, promotion → demand ↑
- Informative adv — information, features of product, positive externalities
- Persuasive adv — persuade, attract, use of celebrity
★ Disadvantages of policies
- Opportunity cost → money could have gone to public goods
- Time consuming → long-term effect
- Expensive
- Difficult to determine the per-unit subsidy / area
★ Note: even if these goods are provided for free, people will still not consume them, as they have lack of information — they don't know the true benefits.
7. Quick Recap / Cheat-Sheet
✓ Market Failure — one-page summary
- Market failure = free market fails to allocate resources per society's view → over/under-allocation → welfare loss
- SC = PC + EC; SB = PB + EB (external = 3rd party)
- Public good: govt, social welfare, taxes — non-rival, non-excludable, non-rejectable → free-rider; Private good: private producer, profit, price mechanism — rival, excludable, rejectable
- Demerit (harmful, SC>PC, cigarettes): over-produced S↑, under-charged P↓, over-consumed D↑ → policies: indirect tax (S↓), negative advertisement (D↓), complete ban, minimum price
- Merit (beneficial, SB>PB, healthcare/education): under-consumed D↓, under-produced S↓ → policies: subsidy (S↑), positive advertisement (D↑)
- Tax & PED: elastic → tax revenue ↓; inelastic → tax revenue ↑ (consumption ↓ in both)
- Policy drawbacks: opportunity cost, time consuming, expensive, hard to fix per-unit subsidy