Chapter 14 IGCSE
Chapter 14 IGCSE
Chapter 14 IGCSE
Market failure
Learning objectives
By the end of this chapter you will be able to:
Define market failure
Distinguish between social, private and
External costs and benefits explain why
External costs and external benefits cause
Market failure explain why information failure
may cause market failure
Learning objectives
Define merit and demerit goods
Explain why merit and dement goods result in market
failure
Define public goods and private goods
Distinguish between private and public goods
Explain why public goods result in market failure
Explain why monopoly power causes market failure
Explain why factor immobility results in market failure
Discuss the consequences of market failure
14.1 The nature of market failure
Market failure occurs when market forces fail
to produce the products that consumers
demand, in the right quantities and at the
lowest possible cost.
Market failure
• In other words market failure arises when
markets are inefficient.
• There are a number of indicators of market
failure including shortages surpluses, high
prices, poor quality and lack of innovation.
Market failure
• If left to market forces, some products may be
under-produced. some over-produced and some
may not be produced at all. Prices may be high
due to lack of competitive pressure and
difficulties in lowering the costs. A lack of
investment and reduction in expenditure on
research and development, can also slow down
the improvement in products.
14.2 Failure to take into account all costs
and benefits
The consumption and production of some products
may affect people who are not involved in their
consumption or production directly (those indirectly
affected are often referred to as third parties). In such
cases the total benefits and total costs to society,
called social benefits and social costs are greater than
the benefits and costs to the consumers and
producers known as private benefits and private
costs.
Example
• For example, the social costs of a firm
producing chemicals will include costs not
only to the firm, but also to people living
nearby.
External costs
• Costs to third parties are called external costs.
Among the private costs to the firm will be the cost
of buying raw materials, fuel and wages. The
external costs imposed on those living nearby may
include noise pollution, air pollution and water
pollution. If the decision to produce chemicals is
based only on the private costs to the firm, there
will be over-production.
External costs
• Figure 14.1 shows that if only the private costs
to the firm are taken into account, then the
supply would be curve SS, whereas the full
cost to society is higher at curve SxSx. The
difference between the two is accounted for
by the external costs. The allocatively efficient
output is Ox. but the market output is Q.
External costs
Under-consumption
• Demand based just on the private benefits to
those consuming the product, will lead to under-
consumption and hence under-production. if the
total benefit to society is greater. For example
among the benefits students may receive by
undertaking university degree courses are
greater number of career choices, higher future
earnings life-long interests and life-long friends.
Under-consumption
• .The social benefits include not only these
private benefits but also the benefits to other
people (external benefits) who will be able to
enjoy a higher quantity and quality of output
as graduates are usually highly productive
workers.
Under-consumption
• In Figure 14.2 the demand for degree courses,
based on private benefits. is curve DD. whilst
the total benefit to the economy is shown by
curve DxDx The number of degree courses
that would be undertaken, if left to market
forces, is 0. whereas the number which would
cause the maximum benefit to the society is
Ox.
Under-consumption
Socially optimum output
• Whenever there is a gap between the total
effects on society, and the effects on those
directly consuming and producing the
products markets will fail to allocate resources
efficiently. The level of output which will cause
maximum benefit to the society (socially
optimum output) will occur when the social
benefit of the last unit produced is equal to
the social cost of that unit.
Socially optimum output
• If the social cost exceeds the social benefit. it
implies that too many resources are being devoted
to the production of the product. Society would
benefit from reducing its output In contrast. if the
benefit society would gain from producing more of
the product is greater than the cost to society of
producing more output then more resources
should be devoted to its production.
The social cost exceeds The social benefit
A Basic necessities
B Capital goods
C Demerit goods
D Public goods
Multiple choice questions
4 What is a cause of market failure?
A Competition between firms
B Consumers lacking information about where the
lowest prices can be found
C Differences in pay between skilled and unskilled
workers
D Resources being both geographically and
occupationally mobile
Answer
1 B
If firms are producing above the lowest
possible cost, they are failing to achieve
productive efficiency. A refers to consumer
sovereignty, which should result in allocative
efficiency. C and D refer to markets adjusting
to changes in market conditions. They should
result in equilibrium being restored,
eliminating shortages and surpluses.
Answer
2 B
One of the characteristics of a merit good is
that it is more beneficial than those
consuming it realise. A merit good does have
external benefits. C refers to a demerit good
and D to a public good.
Answer
3 C
Demerit goods will be over consumed and
hence overproduced, as their harmful effects
on the consumers and others are not fully
appreciated. A and B are likely to be under
produced and D, public goods may not be
produced at all.
Answer
4 B
Information failure is a major cause of market
failure. A, C and D should all promote efficient
working of markets. Competition provides a
‘carrot’ and a ‘stick’ for firms to be efficient.
Differences in pay between skilled and unskilled
workers provide an incentive for workers to be
productive. Mobility of resources makes it easier
and quicker for markets to respond to changes in
consumer demand.
Four-part question
a Define an external cost. (2)
b Explain the difference between a merit and a
demerit good. (4)
c Analyse why the social benefit of education
exceeds the pnvate benefits. (6)
d Discuss whether or not trees in the
rainforests of Brazil should continue to be cut
down. (8)
Answer
A An external cost is a harmful effect on third
parties, that is on people not directly involved
in consuming and producing a product. For
example, people living near a steel factory
may suffer from the pollution the factory
creates.
Answer
B A merit good is one that the government
considers is more beneficial to consumers
than they realise and it generates external
benefits. The social benefit of a merit good
exceeds the private benefits. As a result, a
merit good is under consumed and under
produced if left to market forces.
Answer
In contrast a demerit good is one that the
government thinks is more harmful to
consumers than they appreciate and it causes
external costs. It is over consumed and so
overproduced if left to market forces.
Answer
C Social benefit includes private and external
benefits. The social benefit of education
exceeds the private benefits of education
because education has external benefits. The
private benefits of education include the
development of skills, increased earning
potential and an increased range of interests.
Answer
As well as the benefits to those being educated,
others may gain. The external benefits include
increased output and better quality output due to
higher labour productivity. More and better
products can be consumed. There may also be
increased tax revenue arising from higher incomes.
This extra tax revenue may be spent on, for
example, healthcare, which can be enjoyed by third
parties. A more educated country may also be a
more civilised and compassionate society.
Answer
D The rainforests, in the Amazon region of Brazil, are
being cleared at a relatively rapid rate. The firms that
are engaged in logging in the forests are only taking
into account private costs and benefits. In the case of
a logging firm, private costs will include, for example,
the cost of transporting the wood and the cost of
labour. The private benefit a logging firm receives
from selling the wood is the revenue it earns. The
company will continue cutting down trees, as long as
the revenue received by it exceeds its costs.
Answer
External costs caused by the logging firms may
include damage to wildlife habitats, loss of plant
species that could be used to develop medicines,
global warming and interference with the lifestyle of
local tribes. External benefits may include reduced
transport costs for tourism firms in the area due to
construction of roads by logging firms and tax
revenue. While making its decisions on the number
of trees to be cut down, a logging company will not
take these external costs and benefits into account.
Answer
The decision as to whether trees should
continue to be cut down in the Brazilian
rainforests should be based on the
relationship between social cost and social
benefit. If the social cost exceeds the social
benefit, no more trees should be cut down.