What this lesson teaches
I can explain how public goods, merit and demerit goods, externalities and monopoly power cause market failure.
Syllabus K343, 2.9.3. Causes of market failure: causes relating to public goods, merit goods, demerit goods, external costs and external benefits, abuse of monopoly power
I can explain what market failure leads to: too much or too little consumed, goods not provided, and high monopoly prices.
Syllabus K343, 2.9.4. Consequences of market failure: implications of misallocation of resources in relation to: the over-consumption of demerit goods and goods with external costs, the under-consumption of merit goods and goods with external benefits, the non-provision of public goods, restricted supply causing higher prices under a monopoly
Make a guess
Why will no private firm sell "lighthouse services" to ships passing at night?
- Lighthouses cost too much for any firm to build.
- Ships do not need lighthouses at night.
- Ships see the light free, so firms earn nothing.
Show the answer
Ships see the light free, so firms earn nothing.
A lighthouse is non-excludable. Ship owners can free ride, so no firm can collect enough revenue to provide it.
Markets over-produce goods with external costs, under-produce goods with external benefits, and fail to provide public goods.
Goods with external costs, and demerit goods, are over-consumed. Buyers and sellers ignore the harm to third parties, or underestimate the harm to themselves. More is produced than is best for society.
Goods with external benefits, and merit goods, are under-consumed. People ignore benefits to others, or underestimate benefits to themselves. Too little is produced and consumed.
Public goods are not provided by the market at all. Because no one can be excluded, people can use them without paying. This is the free rider problem, so firms cannot earn revenue.
Monopoly power is also a cause. A monopoly can restrict supply to push up the price, so consumers pay more and buy less than in a competitive market.
- Over-consumption
- Demerit goods and goods with external costs.
- Under-consumption
- Merit goods and goods with external benefits.
- Free rider problem
- People use a public good without paying, so firms will not supply it.
- Monopoly
- Restricts supply, causing higher prices.
Worked example: Writing a market failure chain
Explain why the market over-produces cars in a busy city.
- Identify the external cost: traffic jams and pollution harm other road users and residents.
- Explain why it is ignored: drivers consider only their own fuel and car costs.
- Consequence: more cars are bought and driven than is best for society, so resources are misallocated.
- Link: this is why governments use measures such as road pricing.
Watch out for this
Market failure means the market has collapsed and nothing is sold.
Market failure means the wrong amount is produced: too much, too little or none of a particular good. Most markets with failure still trade.
Check your understanding
Why does the free market fail to provide national defence?
- It has external costs, so a free market would produce too much of it.
- People cannot be excluded from its benefits, so they would not pay for it.
- Demand for defence is price elastic, so firms cannot raise the price.
Show the answer
People cannot be excluded from its benefits, so they would not pay for it.
Right. This free rider problem means firms cannot earn revenue.
Check your understanding
Which of these is a public good?
- Street lighting
- A flu vaccination
- A public housing flat
- A bus ride
Show the answer
Street lighting
Right. No one can be stopped from using it, and one person's use does not reduce another's.