Market failure

Markets usually work well; the price mechanism signals the intentions of buyers and sellers.  There are some situations where the market fails to allocate resources efficiently or equitably.  This chapter will look at the following types of market failure:

  • Negative externalities.
  • Positive externalities.
  • Merit and demerit goods.
  • Public goods.
  • Monopolies.
  • Immobility of factors of production.
  • Inequalities in the distribution of wealth and income.



An externality is the impact on a third party of production or consumption for which no compensation is paid.  Externalities can lead to market failure if the price doesn’t take these spill over effects into account.


The private cost is the direct cost associated with the consumption or production.  The social cost includes all of the possible costs associated with the consumption or production.  If the private cost differs from the social cost then an externality exists:


Social costs = Private costs + Externality


Externalities can be positive or negative depending upon whether the spill over effects are positive or negative.  Smoking will have a negative impact upon society, whilst education will improve the lives of society.


In economics we often look at marginal decisions, that is, the effects of one more.  The marginal cost will be the cost of buying one more and the marginal benefit is the utility received from buying one more.  We are able to adjust the formula written earlier:


Marginal social costs = Marginal private costs + Marginal externality


When a good is sold the market will try and reach an equilibrium, for example, the following diagram:


In this diagram the supply curve is equal to the cost to the seller and the demand curve represents the benefit to the buyer.  The price mechanism will ensure an equilibrium point is reached where the cost equals the benefit (supply = demand).


Negative Externalities from Production

A negative externality from production will exist when the social marginal cost is greater than the private marginal costs.  To put is simply, there will be negative externalities if society suffers costs that the producer hasn’t paid for.  Negative externalities include:

  • Air pollution, for example, emissions from a factory.
  • River/sea pollution, for example, discharge from factories.
  • Noise pollution, for example, from construction or traffic.
  • Increased congestion, for example, due to new shops being built.
  • Unsightly buildings, for example, poor planning regulations allowing buildings to be built.


This diagram demonstrates what will happen when the social marginal cost is greater than the private marginal cost.  The difference between the curves is equal to the negative externality.  Market failure occurs, because if left to the market the equilibrium will only reflects the private costs and benefits, QMARKET will be produced at a price of PMARKET.  The optimum quantity of output will be lower, QOPTIMUM, at a price of POPTIMUM as this reflects the negative externalities society has to suffer.


Positive Externalities from Production

Positive externalities from production are quite similar to external economies of scale, examples are:

  • Training workers that other businesses can use.
  • Carrying out research and development, for example, by firms and universities.
  • Building new infrastructure, for example, roads or broadband connections.


Positive Externalities From Consumption (Merit Goods)

Positive externalities from consumption will occur when an individual consumes a good or service and society benefits as well as the individual; these goods are known as merit goods for example, education, healthcare and pensions.


The following diagram demonstrates a positive externality from consumption.  A perfectly elastic supply curve is used; this means that all quantities are supplied at the same price.


Merit goods under–consumed in the free market, hence the term market failure.  The government acknowledges that individuals will under-consume merit goods if left to their own devices.  It therefore encourages us to consume more by providing free education, healthcare and dental treatment.


Merit goods are an example of market failure as the free market will provide the good, but the lack of information will mean that too little of them will be demanded.


Negative Externalities from Consumption (Demerit Goods)

Consumers may create negative externalities when they consume some goods and services, these are called demerit goods.  They are generally described as being bad for you and those around you, for example, smoking, binge drinking, drug abuse and prostitution.


The diagram below shows the negative externalities from consumption.  It highlights the fact that demerit goods are over-consumed.


The government feels that individuals will over-consume merit goods if left to their own devices; taxes are the main weapon in attempting to reduce consumption, although some goods and services are illegal.  This will be explored in greater detail in the next chapter.


Valuing Externalities

Measuring the exact value of an externality is both difficult and controversial.  There are two ways economists attempt to measure them:

  • Ex-ante – an attempt is made to value what people would be prepared to pay to avoid the externality before it happens
  • Ex-post – this takes place after the externality has occurred and attempts to estimate the cost of correcting the damage.


Placing a value on the harmful effects of an externality is still a problem irrespective of whether the ex-ante or ex-post approach is used.  How do you place a value on a life?  Or river pollution that kills huge numbers of animals and fish?  These are the questions that cause arguments the world over.


Public Goods

Public goods are another example of market failure; they will be under produced if they are produced at all in the free market.  Public goods differ from private goods that are provided by the price mechanism.  Private goods have the following characteristics:

  • Excludability – if a customer doesn’t pay then they can be excluded from consuming it.
  • Rivalry – if somebody consumes a private good then there will be less available for others to buy.
  • Rejectability – if you don’t want to consume a good or service then you don’t have to.  You are free to choose.


The characteristics of a public good differ from a private good, they are:

  • Non excludability – it isn’t possible to exclude people from using the good or service, even if they haven’t paid for it.
  • Non rivalry – if one person consumes a public good, it will not reduce the amount available for others.


Public goods will suffer from the “free rider” principle.  This states that firms can’t charge for a non excludable good because somebody else could use it without paying anything.  Others would gain from the positive externalities of consumption.  A free rider is someone who receives the benefit of the good without paying for it.  Examples of public goods are street lighting, national defence and light houses.


It is because of the free rider principle that private sector firms will not want to supply them, they would be unable to earn a profit.  The market failure occurs, because public goods are in demand, but businesses are unwilling to supply them.  This means that the government will usually have to supply public goods.



A monopoly exists when there is only one firm in a market.  The firm can exist as a monopoly as there will be barriers to entry that will prevent other businesses entering the market, even if large profits are being made.


In reality the government, Competition Commission and other agencies call firms who have more than 25% of any particular market a monopoly.


Monopolies can be:

  • National, for example, Royal Mail in the delivery of letters for less than £1.
  • Regional, for example, water company.
  • Local, for example, post office or chemist in small village.


Barriers to entry

There a number of different examples of barriers to entry:

  • Economies of scale – if the monopoly has already increased production and exploited economies of scale it will have a cost advantage over a new entrant.
  • The new firm would find it hard to compete on price and it would therefore be difficult to become established in the market.  The existing monopolist could lower its price when a new entrant, with higher costs, enters the market.
  • The monopolist might be a natural monopoly, meaning that the market is too small for two businesses, for example, it would not be efficient for two water supply companies to lay all of the pipes and infrastructure to supply homes, or a small town may not be big enough to support two bus companies.
  • Sunk costs – sunk costs are those that can’t be recovered, in other words, the difference between the cost of capital equipment and its resale price, and the costs of advertising. If sunk costs are very high then businesses will be wary of entering a market because the costs of failure will be very high.  Low sunk costs, on the other hand, will not act as a barrier to entry as there will be little to lose.
  • Marketing barriers – if the monopolist spends huge sums on marketing it can lead to brand loyalty.  Any new entrant would have to spend more on marketing than the monopolist if they are going to persuade customers to buy their product, for example, laundry detergent is produced relatively cheaply using low cost technology, in order to erect barriers to entry existing firms spend huge sums advertising; it is estimated that any new entrant would have to spend at least £10 million to launch their product (this is also a sunk cost).
  • Product differentiation – a business maybe able to gain monopoly power if it is able to differentiate its goods or services from its rivals.
  • Capital costs – how expensive is it to set up the business?
  • Patents – if a business owns a patent for its invention then it can prevent other firms from using the idea for up to 20 years, for example, cat’s eyes and Dyson vacuum cleaners.
  • Government licences – some industries are protected from competition by a licence from the government, for example, commercial television and radio, the national lottery, delivery of letters by Royal Mail and the production of nuclear energy.
  • Restrictive practices – this is illegal activity by businesses that aims to erect barriers to entry.  Examples from history are:
    • Stagecoach providing free buses to drive competition out of the market.
    • British Airways were accused of introducing a new airline, Go, with the sole objective of lowering their rival’s soaring profits.
    • Levi wouldn’t sell businesses Levi 501s unless they purchased their whole range.


The demand curve

The downward sloping demand curve for the industry must equal the demand curve for the firm in a monopoly.  This means that the monopolist has the power to be a price maker, in other words, the monopoly can decide what price it wants to sell its products for.  Once the monopolist has decided upon a price it must accept whatever quantity market wishes to buy at that price.


Rather than setting the price, the monopolist may decide to sell a particular quantity and accept the price the market is willing to pay.

The case against monopolies

There are a number of arguments against monopolies that lead economists to describe monopolies as an example of market failure:

  • Higher prices and lower output – the classic argument against monopoly states that a monopolist facing the same costs and demand curve as a competitive industry will produce a lower output at a higher price.
  • Lack of choice – a monopolist will restrict consumer choice and leave them unable to switch to a competitor.
  • Productive inefficient – without competitive pressures the monopolist may not have strive towards reducing costs to their minimum.


The case for monopolies

Despite the strong arguments against monopolies, there are a number of benefits of a monopoly operating in a market:

  • Research and development (R&D) – a monopoly is able to earn higher profits, therefore it is more likely to have the funds available to invest in research and development.
  • Economies of scale – a monopoly will be able to produce at a lower cost than many small firms.
  • International dimension – a business maybe a monopoly in the UK, but it faces a highly competitive marketplace on a global level.


Many of these arguments aren’t limited to monopolies, they are also applicable to large firms that, whilst not the only firm in the market, they do have significant market power.  There are very few examples of true monopolies.


Immobility of Factors of Production

If the factors of production are not mobile it can lead to market failure as resources are not allocated as efficiently as they could be.  There are two main types of immobility, occupational immobility and geographical immobility.


occupational immobility

Some factors of production are very specific to one particular task, in other words, they suffer from immobility.  Others are far more mobile and can be used in different industries.


Some workers will suffer from occupational immobility as they are trained in one particular role and thy will fin it difficult to switch roles.  This is a particular problem for some groups of workers whose industry have almost ceased to exist in the UK.  Workers who don’t have the skills the present job market require as described as being structurally unemployed (see later notes on ‘unemployment’).


geographical immobility

This refers to the fact that factors of production, including labour, may not be able to simply move to where they are required.

Inequalities in the Distribution of Income and Wealth

There are great differences in the wealth and incomes of individuals in a free market.  Incomes are the earnings of an individual over a period of time, whilst wealth refers to assets already owned.  These inequalities and how they change as an economy grows are explored in more detail in the later chapter, ‘conflicts between objectives’.









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