What this lesson teaches
I can define market failure.
Syllabus K343, 2.9.1. Definition of market failure
I can define public, merit and demerit goods, private, external and social costs and benefits, and monopoly.
Syllabus K343, 2.9.2. Definitions of terms associated with market failure: public goods, merit goods, demerit goods, private benefits, external benefits, social benefits, private costs, external costs, social costs, monopoly
Make a guess
A paint factory pays $2,000 a month for fumes filters. Is that an external cost?
- Yes, because the filters protect nearby residents.
- No. The firm pays it, so it is private.
- Yes. Any cost linked to pollution is external.
Show the answer
No. The firm pays it, so it is private.
External costs fall on third parties who are not paid for them. Money the firm itself spends is a private cost.
Market failure happens when the price mechanism allocates resources inefficiently, producing too much or too little.
Market failure is when the market, left alone, fails to allocate resources efficiently. It produces too much of some goods, too little of others, or none at all.
Private costs and benefits are those that fall on the people buying or selling. External costs and benefits fall on third parties: people outside the transaction. Social cost = private cost + external cost. Social benefit = private benefit + external benefit.
A merit good, such as education or vaccination, is more beneficial than people realise and gives external benefits. A demerit good, such as cigarettes, is more harmful than people realise and gives external costs.
A public good, such as street lighting or national defence, is non-rival and non-excludable. One person using it does not reduce what others get, and nobody can be stopped from using it. A monopoly is a single seller of a product.
Sort these
Sort each good into the kind of good it is.
Groups: Merit good, Demerit good, Public good.
- A childhood vaccination
- A pack of cigarettes
- Street lighting
- A can of sugary soft drink
- National defence
- A course of adult education
Show the answer
Merit good
- A childhood vaccination It benefits the child more than parents may realise and protects others too, so it tends to be under-consumed.
- A course of adult education Learners often underestimate its benefits, and employers and society gain too.
Demerit good
- A pack of cigarettes It harms the smoker more than they realise and harms others through second-hand smoke.
- A can of sugary soft drink Drinkers underestimate the long-run harm to their health, so it is over-consumed.
Public good
- Street lighting One person's use does not reduce another's, and no one can be stopped from using it.
- National defence Everyone in the country is protected, payer or not, so the market would not supply it.
- Market failure
- Inefficient allocation of resources by the market.
- Social cost
- Private cost + external cost.
- Social benefit
- Private benefit + external benefit.
- Public good
- Non-rival and non-excludable, such as street lighting.
Worked example: Separating private, external and social costs
A factory produces paint and releases fumes into the air.
- Private costs: what the factory pays for paint ingredients, wages and electricity.
- External costs: nearby residents suffer breathing problems and must clean their homes more often. They did not agree to this and are not paid for it.
- Social cost: private costs plus external costs. This is the full cost to society of making the paint.
Watch out for this
External costs are the extra costs a firm pays for pollution control.
External costs fall on third parties, not on the buyer or seller. If the firm pays, it is a private cost.
Check your understanding
Why is street lighting a public good?
- It is provided by the government.
- It is more beneficial than people realise.
- It is non-rival and non-excludable: one person's use does not reduce another's, and no one can be kept out.
Show the answer
It is non-rival and non-excludable: one person's use does not reduce another's, and no one can be kept out.
Right. These two features make it hard for a firm to charge for it.
Check your understanding
A person gets vaccinated against flu. Who gains an external benefit?
- People around them, who are less likely to catch flu
- The clinic, which earns a fee
- The person vaccinated, who is less likely to fall ill
Show the answer
People around them, who are less likely to catch flu
Yes. They are third parties who gain without paying.