When do free markets fail to allocate resources well, and how can the government step in?
What market failure is, the main causes (externalities, merit and demerit goods, public goods), and how the government can intervene to correct it.
An OCR J205 answer on market failure: externalities, merit and demerit goods and public goods, why markets misallocate resources, and how government intervention can correct it.
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What this dot point is asking
OCR wants you to explain what market failure is, the main causes (externalities, merit and demerit goods, public goods), and how the government can intervene to correct it. This is where the case for government in a mixed economy is made.
What market failure is
Market failure is the main economic justification for government intervention. Without it, free markets would be left to allocate everything.
Externalities
- With negative externalities, the market over-produces, because firms and buyers ignore the cost to others (for example pollution).
- With positive externalities, the market under-produces, because buyers ignore the benefit to others (for example education or vaccination).
Merit and demerit goods
Public goods
Because the market will not provide public goods, the government usually supplies them, funded by taxation.
How the government intervenes
The government has several tools to correct market failure:
- Indirect taxes on goods with negative externalities or demerit goods, raising their price to cut consumption.
- Subsidies for goods with positive externalities or merit goods, lowering their price to raise consumption.
- Regulation and laws (bans, age limits, emission standards) to restrict harmful activity.
- Information and education to change tastes (anti-smoking campaigns, health warnings).
- Direct provision of public and merit goods (state schools, the NHS, street lighting).
Try this
Q1. Define a public good. [2 marks]
- Cue. A good that is non-excludable and non-rival, so the market under-provides it (for example street lighting).
Q2. Explain one way the government could increase the consumption of a merit good. [3 marks]
- Cue. A subsidy lowers the price (or direct provision makes it free), raising consumption towards the socially desirable level.
Exam-style practice questions
Practice questions written in the style of OCR exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
OCR J205/02 20194 marksExplain what is meant by a negative externality, using an example.Show worked answer →
A 4 mark Explain question.
A negative externality is a cost imposed on a third party not involved in a transaction, for which no payment is made. An example is a factory whose pollution harms nearby residents who are not buyers or sellers of its product.
Because the firm and its customers do not pay this cost, the market over-produces the good. Markers reward the third-party cost idea, a valid example, and ideally the point that the good is over-produced.
OCR J205/02 20226 marksDiscuss how the government could reduce the consumption of a demerit good such as tobacco.Show worked answer →
A 6 mark evaluative question.
Methods: an indirect tax raises the price, cutting demand; regulation (age limits, bans on smoking in public places) restricts use; and information/education about the harms reduces demand by changing tastes.
Evaluation: taxes raise revenue and cut consumption but, because tobacco is addictive (inelastic demand), may not cut it much and hit the poor hardest; bans can be hard to enforce; education is slow. Markers reward at least two methods and a judgement, for example that a mix of tax, regulation and education works better than any one alone.
Related dot points
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An OCR J205 answer on taxation and government spending: direct versus indirect taxes, progressive versus regressive taxes, the main areas of public spending, and why governments tax.
- What fiscal policy is, how changes in government spending and taxation affect growth, employment and prices, and the costs and benefits of using it.
An OCR J205 answer on fiscal policy: how government spending and taxation are used to pursue economic objectives, their effect on growth, employment and inflation, and the trade-offs involved.
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An OCR J205 answer on what competition means and its economic impact on producers and consumers: lower prices, more choice, better quality, innovation and efficiency, with the limits of competition.
- The difference between income and wealth, the meaning of a fair distribution, the causes of inequality and poverty, and how government can redistribute.
An OCR J205 answer on the distribution of income and wealth: the difference between the two, the causes of inequality and poverty, and how governments redistribute through tax and benefits.
- The government's main economic objectives (growth, low unemployment, price stability and a fair distribution of income), and why they can conflict.
An OCR J205 answer on the government's main macroeconomic objectives (economic growth, low unemployment, price stability and a fair distribution of income) and the trade-offs between them.
Sources & how we know this
- OCR GCSE (9-1) Economics J205 specification — OCR (2017)