What this lesson teaches
I can explain the causes of market failure: public goods, externalities and information failure.
Syllabus 8843, 2.2.2(b). Market Failure and its Causes: Markets may fail in terms of; non-provision of public goods due to non-rivalry and non- excludability; non-socially optimal levels of goods and services due to the presence of externalities and/or information failure
Make a guess
Left to the free market, will people get the right number of flu vaccinations?
- Too many, because vaccines are good for health.
- Too few, because people ignore the benefit to others.
- The right number, because people know their own health.
Show the answer
Too few, because people ignore the benefit to others.
Each vaccinated person also protects family and colleagues. Buyers weigh only their own benefit, so the market gives fewer vaccinations than is best for society.
When an activity benefits third parties, the free market produces too little of it.
A positive externality is a benefit to third parties that the buyer or seller does not get paid for. Vaccinations, education and training are examples.
Consumers consider only their private benefit (MPB). The benefit to society, the marginal social benefit (MSB), is MPB plus the marginal external benefit (MEB).
The free market produces where MPB = MPC, at Qp. The efficient output is where MSB = MSC, at Qs. Since MSB is above MPB, Qp is less than Qs: the good is underconsumed.
Positive externalities can also come from production. When a firm does research, its new ideas spread to other firms through staff who move on, published patents and copied methods. Society's cost of the research is then below the firm's own cost: MSC is MPC minus the external benefit. The firm produces where MPB = MPC, so it does less research than is efficient.
This is one reason governments fund research. Under its Research, Innovation and Enterprise 2025 plan, Singapore committed about S$25 billion to research and innovation from 2021 to 2025, including grants for firms to work with universities.
Goods that society thinks people should consume more of, because of these wider benefits, are often called merit goods.
- MSB
- MPB + MEB.
- Result
- Qp < Qs: underconsumption.
- Production externality
- MSC = MPC - MEB, such as research spillovers; too little is produced.
- Example
- Training and SkillsFuture; research grants under RIE2025.
Worked example: Workers who train
A worker takes a course that makes them more productive.
- The worker gains a higher wage: the private benefit.
- Their employer and co-workers also gain, from fewer mistakes and shared skills: external benefits.
- The worker ignores these, so too little training happens: Qp is below Qs.
- SkillsFuture credits and course subsidies lower the cost of training to encourage more of it.
Watch out for this
A positive externality means the market overproduces, because the good is beneficial.
It is the opposite. Buyers ignore the benefits to others, so they buy too little.
Check your understanding
A flu jab costs $30. It gives the person $25 of benefit and protects others by $15. Will the person buy it, and should society want them to?
- No, and society agrees, because the person's $25 benefit is below the cost.
- Yes, because the total benefit of $40 is more than the $30 cost.
- No, but society should: the $40 total benefit to everyone is above the $30 cost.
Show the answer
No, but society should: the $40 total benefit to everyone is above the $30 cost.
Right. The person weighs only their own $25 against $30 and skips it. Adding the $15 external benefit makes the social benefit $40, above the cost, so too few jabs are bought.