Causes & Consequences of Market Failure (Cambridge (CIE) IGCSE Economics): Revision Note

Causes of market failure

• Market Failure occurs when free market activity results in a less than optimum allocation of resources from the point of view of society

Causes of market failure

Demerit goods

• These are goods that are over-consumed because individuals underestimate how harmful they are to themselves

  • The focus is on the individual’s misjudgement of private harm

  • These goods are often addictive

    • For example, gambling, alcohol, drugs, sugary foods and drinks

Merit goods

• These are goods that are beneficial to society but consumers under-consume them as they do not fully recognise the private benefits

  • Consumers make poor decisions due to lack of information or short-term thinking

    • For example. vaccinations, education, electric cars

Public goods

• Public goods are beneficial to society but would be underprovided by a free market

• Public goods are goods that are:

  • Non-excludable: you can't stop someone from using them

  • Non-rivalrous: one person’s use doesn’t reduce availability for others

• Due to the above two factors, there is little opportunity for sellers to make profits from providing these goods and services

  • Examples include national defence, parks, libraries and lighthouses

Abuse of monopoly power

• The development of monopoly markets is a natural outcome of a market system

• Firms seek to eliminate competition by buying out competitors and increasing their ownership of factors of production

• With less competition, firms can raise prices, reduce the choice available to consumers, or limit the supply  

External costs and benefits

• Externalities occur when there is an external cost or external benefit on a third party not involved in the economic transaction

  • The price mechanism in a free market ignores these externalities

• If these external costs/benefits were acknowledged, then the price and output in the market would be different

Summarising some key differences

The difference between merit goods and external benefits

• Many merit goods also create external benefits, so they are common causes of market failure. But they are not identical:

The difference between demerit goods and external costs

• Many demerit goods also create external costs, so they are common causes of market failure. But they are not identical: