IB Economics/Microeconomics/Market Failure

2.4 Market FailureEdit


When the price mechanism fails to take into account all the costs and/or benefits in providing and/or consuming the good, the market will fail to supply the socially optimal amount

  • The competitive forces of supply and demand will not produce quantities of goods where the prices reflect the marginal benefit (utility) of consumption - this in turn leads to over-/under consumption of the good, i.e. allocative inefficiency

Reasons for market failureEdit


Most markets are NOT successful, and the government intervenes to some degree

  • Perfect markets are socially efficient, they are operating at Pareto optimality in which no one can be made better off with someone being made worse off (zero sum)
  • Consumer surplus is maximized
  • P=MC where MSC=MSB
  • In the real world, markets are not perfect; MSC does not equal MSB and market failure occurs
  • This is because of externalities, underprovision of merit goods, the overprovision of demerit goods, a lack of public goods, and imperfect markets
  • If the free market is left to its own devices, Pareto market failure will occur
  • Inefficient Producers: producers do not produce where the average costs are at minimum
  • Therefore they are using more resources than they need to
  • Positive and Negative externalities: an externality is an effect on a third party which is caused by the consumption and/or production of a good or service
  • There are four types of externalities
  • Short-term and long-term environmental concerns, with reference to sustainable development
  • Lack of public goods : public goods are goods which total cost of production does not increase with the number of consumers


Public goods are:
1. non-rivalrous (consumption by one consumer will not reduce the amount available for other consumers in the market, i.e. they do not have to compete to obtain the good/service)
2. non-excludable (no consumer is excluded from consuming such good/service)

  • The classic example is national defence
  • Other examples: street lights, roads
  • Public goods will not be provided by the market
  • Underprovision of merit goods: if left to its own devices, merit goods (a private good that society considers underconsumed, often with positive externalities) will be underprovided
  • These are goods and services which have a positive effect on society like education, healthcare and sports centers
  • Overprovision of demerit goods: if left to its own devices, demerit goods (a private good that society considers overconsumed, often with negative externalities) will be overprovided
  • These are such things as prostitution, alcohol and cigarettes
  • To discourage these demerit goods the government creates: negative advertising, tax on the good, or bans it altogether
  • Abuse of monopoly power: imperfect markets such as oligopolies and monopolies restrict output in an attempt to maximize profit
  • Thus, MSB is not equal to MSC / MSC is equal to MR

Possible government responsesEdit


  • Legislation: antitrust legislation can be brought in an attempt to break monopoly power and collusive oligopolies
  • Legislation to make high school attendance mandatory
  • Ban smoking in restaurants
  • Direct provision of merit and public goods: governments can control the supply of goods that have positive externalities by supplying a high amount of education, public roads, parks, libraries, etc.
  • Taxation: place a 'sin tax' on the sale of tobacco products to discourage consumption
  • This will internalize some of the external costs (i.e., smokers will pay for their second hand smoke through the tax)
  • Subsidies: reduce the cost of university education because it has beneficial externalities
  • The price will be reduced to reflect the benefit society attains through the education of individuals
  • Tradable permits: tradable permits are permits allowing a firm to produce a given amount of pollution
  • There is limited supply for how much pollution a firm can produce so if a firm would want to pollute more it has to purchase tradable permits from other firms
  • A Carbon Tax (taxing consumption which causes pollution, such as fossil fuels) achieves the same result
  • In both cases, firms and individuals are motivated to reduce costs by reducing environmental damage
  • Extension of property rights: form of privatization to privatize certain non-private goods
  • e.g., lakes, rivers, beach=> create a market for pollution and charge people if they want to pollute something
  • Advertising to encourage and discourage consumption:
  • International cooperation among governments: in the case of acid rain, for example international cooperation among governments is necessary in order to reduce its occurrence
Last modified on 19 November 2012, at 09:01