Explain market failure through externalities, merit and demerit goods, public goods and the under-provision or over-provision of goods, and evaluate government responses such as taxes, subsidies, regulation and provision.

What this dot point is asking

Markets usually allocate resources well, but sometimes they fail, and CCEA expects you to explain when and why. You must define market failure, explain externalities (the spillover costs and benefits ignored by the market), merit and demerit goods (over- or under-consumed), and public goods (which markets struggle to provide). You must then evaluate the government's tools for correcting failure: taxes, subsidies, regulation, bans and direct provision. This is the part of Section 1 that bridges microeconomics and government policy, and it is a favourite for longer evaluation questions.

What market failure is

A market failure occurs when the free market, left alone, does not allocate resources in the best interests of society: it produces too much of some goods and too little of others. The price mechanism works well most of the time, but it can misfire when private decisions ignore wider costs and benefits, or when a good cannot easily be bought and sold.

Externalities

An externality is a cost or benefit of an economic activity that falls on a third party: someone outside the decision to produce or consume. Because the market price ignores these spillovers, the wrong quantity is produced.

A negative externality is a spillover cost. A factory polluting a river imposes costs on residents and anglers who had no say in the decision. The firm does not pay for the damage, so its price is too low and too much of the good is produced. Other examples are traffic congestion, noise and second-hand smoke.

A positive externality is a spillover benefit. When someone is vaccinated or educated, others benefit too (less disease, a more skilled workforce). Because buyers ignore the benefit to others, too little is produced and consumed.

Merit goods, demerit goods and public goods

Merit goods are goods that are better for people and for society than they realise, so they are under-consumed if left to the market: education, healthcare and exercise are examples. They usually carry positive externalities.

Demerit goods are worse for people and society than they realise, so they are over-consumed: cigarettes, alcohol and junk food. They usually carry negative externalities, and consumers underestimate the long-term harm.

Public goods have two features: they are non-excludable (you cannot stop non-payers using them) and non-rival (one person using them does not reduce the amount left for others). Street lighting, national defence and flood barriers are examples. Because of the free-rider problem, people can enjoy them without paying, so private firms cannot make a profit and will not supply them. The market provides little or none, so the government must.

Government responses to market failure

CCEA expects you to know the main tools and to weigh them up.

• Indirect taxes raise the price of goods with negative externalities or demerit goods, cutting consumption and raising revenue. They work less well when demand is inelastic.
• Subsidies lower the price of goods with positive externalities or merit goods, encouraging consumption, but they cost the taxpayer money.
• Regulation and laws set rules: emission limits, age restrictions, compulsory schooling. They can be effective but cost money to monitor and enforce.
• Bans outlaw the worst demerit goods, but can create black markets.
• State provision means the government supplies the good itself, free or subsidised, as with the health service, state schools and public goods like defence.

Why this matters

Market failure is the bridge from the market system to government policy and explains why governments tax, subsidise, regulate and provide. It is examined through extended evaluation questions, where you are expected not just to describe a policy but to weigh its strengths against its weaknesses and reach a judgement. The ideas of externalities and merit and demerit goods reappear in the national economy and environmental topics, so a firm grasp here is widely rewarded.