Market failure

Economics · The allocation of resources. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Market failure happens when the free market, left to itself, does not allocate resources efficiently. Too much of some goods is produced and too little, or none, of others.

The main reason is that buyers and sellers look only at their own private costs and benefits. They ignore the effects on other people, called third parties. A factory that pollutes a river creates an external cost. A vaccinated child protects others, which is an external benefit.

So demerit goods and goods with external costs are over-consumed. Merit goods and goods with external benefits are under-consumed. Public goods are not provided at all, and a monopoly may restrict supply to push up its price.

Rules to remember

Social cost = private cost + external cost
Social benefit = private benefit + external benefit
Public good: non-excludable (people who do not pay cannot be stopped from using it) and non-rival (one person's use does not reduce what is left for others), e.g. street lighting, national defence
Free rider problem: people can use a public good without paying, so private firms cannot make a profit and do not supply it
Merit good: more beneficial than people realise, so under-consumed, e.g. education, vaccinations
Demerit good: more harmful than people realise, so over-consumed, e.g. cigarettes
Monopoly: a single seller; it may restrict supply, so prices are higher and too few resources go into the good

Common mistake

Calling anything the government provides a public good. Schools and hospitals are merit goods, not public goods, because people can be excluded from them and places are limited.

Worked example

A chemical factory has private costs of Rs 120 million a year and causes external costs of Rs 35 million a year. The social benefit of its output is Rs 140 million a year. Is too much or too little being produced?

Social cost = private cost + external cost = 120 + 35 = Rs 155 million.
Compare with social benefit: 155 − 140 = Rs 15 million, so social cost is greater than social benefit.
The firm ignores the Rs 35 million external cost, so it produces more than is best for society.

Answer: Social cost is Rs 155 million, which is Rs 15 million more than the social benefit. Too much is being produced (over-production).

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