The types of market failure - externalities, public goods, merit and demerit goods, information failure, and the abuse of monopoly power - and the resulting welfare loss.

What this dot point is asking

CCEA wants you to define market failure, identify and explain its main types - externalities (positive and negative, in production and consumption), public goods, merit and demerit goods, information failure, factor immobility and the abuse of monopoly power - and use the marginal social cost and benefit framework to show the resulting misallocation and welfare loss.

What market failure means

The social optimum is where marginal social benefit (MSB) equals marginal social cost (MSC). Whenever private and social values diverge, the free market settles at the wrong quantity and a welfare loss results.

Externalities

• Negative production externality (for example, factory pollution): social cost exceeds private cost, so the market over-produces beyond the optimum.
• Negative consumption externality (for example, passive smoking): social benefit is below private benefit, so the market over-consumes.
• Positive production externality (for example, a firm training workers who later benefit others): social cost is below private cost, so output is too low.
• Positive consumption externality (for example, vaccination protecting others): social benefit exceeds private benefit, so the market under-consumes.

Public goods

Because non-payers cannot be excluded, each consumer has an incentive to free-ride - to let others pay and then enjoy the good for nothing. If everyone free-rides, no revenue is raised, so a profit-seeking firm cannot cover its costs and the good is not provided at all. This missing market is why public goods are normally supplied by the government and funded through taxation. Quasi-public goods (such as a toll road or a beach) have the features only partly.

Merit, demerit and information failure

Other sources of failure

The market can also fail through factor immobility - labour and capital cannot move quickly between regions or industries, so unemployment and shortages persist - and through the abuse of monopoly power, where a dominant firm restricts output and raises price above the competitive level, reducing consumer surplus and creating allocative inefficiency.

Try this

Q1. Distinguish between a positive and a negative externality. [2 marks]

• Cue. A positive externality is a benefit to a third party (social benefit exceeds private); a negative externality is a cost to a third party (social cost exceeds private).

Q2. Explain why a free market under-consumes merit goods such as education. [4 marks]

• Cue. Information failure means consumers undervalue the long-term private and external benefits, so they buy less than the socially optimal amount.

Q3. Using a diagram, explain how a positive consumption externality leads to market failure. [6 marks]

• Cue. MSB lies above MPB; the market produces where MPB equals MSC, below the optimum where MSB equals MSC, so the good is under-consumed and there is a welfare loss.