Market failure: externalities, public and merit goods, monopoly power, information failure and inequality.

What this dot point is asking

WJEC wants you to explain the main sources of market failure (externalities, public and merit goods, monopoly power, information failure and inequality) and to show, with diagrams, how each leads to a misallocation of resources.

The answer

Externalities

With a negative externality (such as pollution from production), the marginal social cost exceeds the marginal private cost. The free market produces where private cost equals private benefit, which is more than the social optimum where social cost equals social benefit, so the good is over-produced and there is a deadweight welfare loss. With a positive externality (such as the benefits of education spilling over to society), marginal social benefit exceeds marginal private benefit, so the market under-produces. In both cases output diverges from the socially efficient quantity.

Public goods, merit goods and information failure

Pure public goods such as national defence, street lighting and flood defences must be provided collectively, normally by the state through taxation. Information failure is a further source of market failure: when information is imperfect or asymmetric (one party knows more than the other), agents make decisions that are not in their own or society's interest. Merit goods are often under-consumed partly because of information failure; demerit goods (cigarettes, gambling) are over-consumed for the same reason. Asymmetric information also causes problems such as adverse selection and moral hazard in insurance markets.

Monopoly power and inequality

A firm with monopoly power can restrict output and raise price above the competitive level, reducing consumer surplus and allocative efficiency and creating a welfare loss; this is examined more fully in the A2 theory of the firm. Inequality is a distributional market failure: a free market rewards those with the most productive resources and ignores fairness, so it can generate wide gaps in income and wealth that society judges unacceptable and that may themselves reduce economic efficiency and social cohesion. These failures provide the rationale for the government intervention examined in the next topic.

Examples in context

Example 1. Pollution and congestion in UK cities. Road transport generates classic negative externalities: congestion, air pollution and carbon emissions impose costs on third parties not paid by the driver. The free market therefore over-produces car journeys. UK responses, such as the London congestion charge and clean-air zones, are attempts to internalise the externality by making drivers pay closer to the social cost, illustrating both the failure and its correction.

Example 2. Vaccination as a merit good with positive externalities. Vaccination has large positive externalities (herd immunity protects others) yet individuals may under-value it because of information failure or because they ignore the benefit to others, so a free market would under-provide it. This is why the UK funds vaccination programmes publicly and runs information campaigns: a clear case of a merit good with positive externalities justifying government intervention.

Try this

Q1. Define a public good. [2 marks]

• Cue. A good that is non-rival (one person's use does not reduce the amount available to others) and non-excludable (people cannot be prevented from consuming it).

Q2. Explain why a negative externality leads to over-production. [3 marks]

• Cue. The marginal social cost exceeds the marginal private cost, but the market produces where private cost equals private benefit, which is beyond the social optimum where social cost equals social benefit, so output is too high.