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CIE IGCSE Economics Your notes
2.10 Market Failure
Contents
2.10.1 Market Failure Terminology
2.10.2 Causes & Consequences
2.10.3 Government Intervention to Address Market Failure
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2.10.1 Market Failure Terminology
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Market Failure Defined
In a free market, the price mechanism determines the most efficient allocation of scarce
resources in response to the competing wants and needs in the marketplace
Scarce resources are the factors of production (land, labour, capital, enterprise)
Free markets often work very well
However, there is sometimes a less than optimum allocation of resources from the point of
view of society. This is called Market Failure
Sometimes there is an over-provision of goods/services which are harmful (demerit goods)
& therefore an over-allocation of the resources (factors of production) used to make these
goods/services e.g. cigarettes
Sometimes there is an under-provision of the goods/services which are beneficial (public
goods & merit goods) & therefore an under-allocation of the resources (factors of
production) used to make these goods/services e.g. schools
Sometimes the market causes a lack of equity (inequality) - the rich get richer and the poor
get relatively poorer
Sometimes, environmental damage occurs during the production or consumption of a
good/service
In each of these cases, from society’s point of view there is a lack of efficiency in the allocation
of resources
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Private, Social & External Costs
Externalities occur when there is an external impact on a third party not involved in the Your notes
economic transaction between the buyer & seller
These impacts can be positive or negative & are often referred to as spillover effects
These impacts can be on the production side of the market (producer supply) or on the
consumption side of the market (consumer demand)
External costs occur when the social costs of an economic transaction are greater than the
private costs
A private cost for the producer, consumer or government is what they actually pay to
produce or consume a good/service e.g. a consumer pays $9 for a McDonald's meal
An external cost is the damage not factored into the market transaction e.g. the consumer
throws their McDonalds packaging onto the street & the Government has to hire cleaners to
collect the litter
The social cost includes both the private cost & the cost to society
It is a better reflection of the true cost of an economic transaction
Social cost = private cost + external cost
Private, Social & External Benefits
External benefits occur when the social benefits of an economic transaction are greater than
the private benefits
A private benefit for a consumer, producer or government is what they actually gain from
producing or consuming a good/service e.g. a bee farm gains the private benefit of the
income from selling their honey
An external benefit (positive externality) is the benefit not factored in to the market
transaction e.g. The bees from the bee farm pollinate the nearby apple orchards
The social benefit includes both the private benefit & the external benefit to society
It is a better reflection of the true benefit of an economic transaction
Social benefit = private benefit + external benefit
Exam Tip
Market failure results in the overconsumption of demerit goods & goods with external costs &
the underconsumption of merit goods & goods with external benefits. Your understanding of
this concept is frequently tested in MCQ.
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2.10.2 Causes & Consequences
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Causes & Consequences of Market Failure
Market Failure occurs when free market activity results in a less than optimum allocation of
resources from the point of view of society
The Causes & Consequences of Market Failure
Cause Explanation Consequences
Demerit Goods These are goods which have They are over-provided in a market
harmful impacts on and their consumption often creates
consumers/society external costs
They are often addictive Governments often have to regulate
E.g. Gambling, alcohol, drugs, these goods in such a way that they
sugary foods/drinks raise the prices and/or limit the
quantities consumed
Merit Goods These are goods that are They are under-provided in a market
beneficial to society but & their consumption generates both
consumers under-consume private and/or external benefits
them as they do not fully Governments often have to subsidise
recognise the private or external these goods in order to lower the
benefits price and/or increase the quantities
E.g. Vaccinations, education, consumed
electric cars
Public Goods Public goods are beneficial to Non-excludability refers to the
society but would be under- inability of private firms to exclude
provided by a free market as certain customers from using their
there is little opportunity for products. In effect, the price
sellers to make profits from mechanism cannot be used to
providing these goods/services exclude customers e.g. street lighting
as they are non-excludable and Non-rivalry refers to the inability of
non-rivalrous in consumption the product to be used up, so there is
Good examples include national no competitive rivalry in consumption
defence, parks, libraries and to drive up prices and generate
lighthouses profits for firms
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Therefore, governments will often
provide these beneficial goods
themselves, and so they are called Your notes
public goods
Abuse of The development of monopoly The outcome is that goods/services
Monopoly Power markets is a natural outcome of a are purposely under-provided in
market system order to raise prices and profits
Firms seek to eliminate Governments often intervene to
competition by buying out ensure that there is healthy
competitors & increasing their competition in markets & sufficient
ownership of factors of provision of goods/services
production
With less competition, firms can
raise prices, reduce the choice
available to consumers, or limit
the supply
Factor Immobility Factor immobility occurs when it Factor immobility results an inefficient
is difficult for factors of allocation of resources in a market
production to move or switch (usually under-provision)
between different Governments often implement
uses/locations programs to reduce the factor
The two main types of factor immobility in order to raise
immobility are the geographical & production & output
occupational immobility of
labour
External Costs & Externalities occur when there is A positive externality of
Benefits an external cost or benefit on a consumption occurs when there is a
third party not involved in the positive external benefit in
economic transaction consumption, such as when electric
These impacts can be positive or vehicles are consumed CO2
negative emissions fall
The price mechanism in a free A positive externality of production
market ignores these externalities occurs when there is a positive
If these external costs/benefits external benefit in production, such as
were acknowledged, then the when managed pine forests produce
price and output in the market timber but also increase CO2
would be different absorption
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A negative externality of
consumption occurs when there is an
external cost in consumption such as Your notes
when the consumption of alcohol
increases anti social behaviour
A negative externality of production
occurs when there is an external cost
in production such as when the
production of electricity increases air
pollution
Exam Tip
When explaining externalities, your syllabus focusses on the external costs & benefits. It does
not specifically refer to negative/positive externalities of production or consumption. That
language has been included here as it helps to deepen your understanding which will help you to
better answer both MCQ & structured questions on market failure. You can use this economic
language knowing it will enhance your answers.
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2.10.3 Government Intervention to Address Market Failure
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Intervention to Address Market Failure
Four of the most commonly used methods to address market failure in markets are indirect
taxation, subsidies, maximum prices, & minimum prices
Additional methods of intervention include regulation, nationalisation, privatisation, & State
provision of public goods
Exam Tip
The material on this page is frequently examined in the Paper 2 structured questions. You will be
asked to evaluate the effectiveness of taxes, subsidies, maximum & minimum prices. To do so:
1. Consider the advantages & disadvantages of each method of intervention
2. Explain that several methods of intervention are likely to be more effective than a single
method e.g. smoking is taxed & highly regulated (age restrictions, packaging restrictions,
display restrictions)
3. Consider different market segments & their responsiveness e.g. wealthy consumers will less
responsive (inelastic demand) to tax increases than poorer consumers (elastic demand)
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Maximum Prices
A maximum price is set by the government below the existing free market equilibrium price & Your notes
sellers cannot legally sell the good/service at a higher price
Governments will often use maximum prices in order to help consumers. Sometimes they are
used for long periods of time e.g. housing rental markets. Other times they are short-term
solutions to unusual price increases e.g. petrol
The maximum price (Pmax) sits below the free market price (Pe ) & creates a condition of excess demand
(shortage)
Diagram Analysis
The initial market equilibrium is at Pe Q e
A maximum price is imposed at Pmax
The lower price reduces the incentive to supply & there is a contraction in QS from Q e → Q s
The lower price increases the incentive to consume & there is an extension in QD from Q e →
Qd
This creates a condition of excess demand Q s Q d
The Advantages & Disadvantages of Using Maximum Prices
Advantages Disadvantages
Some consumers benefit as they purchase at Some consumers are unable to purchase
lower prices due to the shortage
They can stabilise markets in the short-term The unmet demand usually encourages the
during periods of intense disruption e.g. creation of illegal markets (black/grey
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Covid supplies at the start of the pandemic markets) as desperate buyers turn to illegal
bidding
Maximum prices distort market forces & Your notes
therefore can result in an inefficient
allocation of scarce resources e.g. maximum
prices in rentals in the property market create
a shortage
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Minimum Prices
A minimum price is set by the government above the existing free market equilibrium Your notes
price & sellers cannot legally sell the good/service at a lower price
Governments will often use minimum prices in order to help producers or to decrease
consumption of a demerit good e.g. alcohol
The imposition of a minimum price (Pmin) above the free market price (Pe ) creates a condition of excess
supply (surplus)
Diagram Analysis
The initial market equilibrium is at Pe Q e
A minimum price is imposed at Pmin
The higher price increases the incentive to supply & there is an extension in QS from Q e → Q s
The higher price decreases the incentive to consume & there is a contraction in QD from Q e
→ Qd
This creates a condition of excess supply Q d Q s
The Advantages & Disadvantages of Using Minimum Prices In Product Markets
Advantages Disadvantages
In agricultural markets, producers benefit as It costs the government to purchase the
they receive a higher price (Governments will excess supply & an opportunity cost is
often purchase the excess supply & store it involved
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or export it) Farmers may become over-dependent on
the Government's help
When used in demerit markets, output Your notes
falls (Governments will not purchase the Producers lower output which may result in an
excess supply of a demerit good) increase in unemployment in the industry
Producers usually lower their output in the
market to match the QD at the minimum price
& this helps to reduce the external costs
Minimum Prices in Labour Markets
Minimum prices are also used in the labour market to protect workers from wage exploitation
These are called national minimum wages
A national minimum wage (NMW) is a legally imposed wage level that employers must pay their
workers
It is set above the market rate
The minimum wage/hour varies based on age
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Your notes
A national minimum wage (NMW1) is imposed above the market wage rate (We ) at W1
Diagram Analysis
The demand for labour (DL) represents the demand for workers by firms
The supply of labour (SL) represents the supply of labour by workers
The market equilibrium wage & quantity for truck drivers in the UK is seen at We Q e
The UK government imposes a national minimum wage (NMW) at W1
Incentivised by higher wages, the supply of labour increases from Q e to Q s
Facing higher production costs, the demand for labour by firms decreases from Q e to Q d
This means that at a wage rate of W1 there is excess supply of labour & the potential for
unemployment equal to Q d Q s
The Advantages & Disadvantages of a Minimum Wage In Labour Markets
Advantages Disadvantages
Guarantees a minimum income for the lowest Raises the costs of production for firms who
paid workers may respond by raising the price of
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Higher income levels help to increase goods/services
consumption in the economy If firms are unable to raise their prices, the
May incentivise workers to be more introduction of a minimum wage may force Your notes
productive them to lay off some workers (increase
unemployment)
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Indirect Taxation
An indirect tax is paid on the consumption of goods/services Your notes
It is only paid if consumers make a purchase
It is usually levied by the government on demerit goods to reduce the quantity demanded
(QD) and/or to raise government revenue
Government revenue is used to fund government provision of goods/services e.g
education
Indirect taxes are levied by the government on producers. This is why the supply curve shifts
Producers and consumers each pay a share (incidence) of the tax
The impact of an indirect tax is split between the consumer (A) & the producer (B)
Diagram Analysis
The government places a specific tax on a demerit good
The supply curve shifts left from S1→S2 by the amount of the tax
The price the consumer pays has increased from P1 before the tax, to P2 after the tax
The price the producer receives has decreased from P1 before the tax to P3 after the tax
The government receives tax revenue = (P2 -P3) x Q 2
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The consumer incidence (share) of the tax is equal to area A: (P2 -P1) x Q 2
The producer incidence (share) of the tax is equal to area B: (P1-P3 ) x Q 2
The QD in this market has decreased from Q 1→Q 2 Your notes
If the decrease in QD is significant enough, it may force producers to lay off some workers
The Advantages & Disadvantages Of Indirect Taxes
Advantages Disadvantages
Reduces the quantity demanded of demerit The effectiveness of the tax in reducing the
goods use of demerit goods depends on the price
Raises revenue for government programs elasticity of demand (PED)
Many consumers who purchase products
that are price inelastic in demand will
continue to do so
It may help create illegal markets as
consumers seek to avoid paying the taxes
Producers may be forced to lay off some
workers as output falls due to the higher
prices
Exam Tip
This further develops the exam tip mentioned above. When analysing the impact of taxes on a
market it is worth highlighting the elasticity of the product as it influences who pays more of the
tax (producer or consumer).
The more price inelastic the product, the greater the proportion of the tax will be passed on to
consumers by producers as the QD will fall less proportionately than the price increase. The
more price elastic the product, the smaller the proportion of the tax will be passed on to
consumers by producers as the QD will fall more proportionately than the price increase.
(See sub-topic 2.7.2 for more on PED)
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Producer Subsidies
A producer subsidy is a per unit amount of money given to a firm by the government Your notes
To increase production
To increase the provision of a merit good
The way a subsidy is shared between producers & consumers is determined by the price
elasticity of demand (PED) of the product
Producers keep some of the subsidy & pass the rest on to the consumers in the form of
lower prices
A diagram which demonstrates the cost of a subsidy to the government (A+B) and the share received by
the consumer (A) & producer (B)
Diagram Analysis
The original equilibrium is at P1Q 1
The subsidy shifts the supply curve from S → S + subsidy:
This increases the QD in the market from Q 1→Q 2
The new market equilibrium is P2 Q 2
This is a lower price and higher QD in the market
Producers receive P2 from the consumer PLUS the subsidy per unit from the government
Producer revenue is therefore P3 x Q 2
Producer share of the subsidy is marked B in the diagram
The subsidy decreases the price that consumers pay from P1 → P2
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Consumer share of the subsidy is marked A in the diagram
The total cost to the government of the subsidy is (P3 - P2 ) x Q 2 represented by area A+B
Your notes
The Advantages & Disadvantages Of Producer Subsidies
Advantages Disadvantages
Can be targeted to helping specific Distorts the allocation of resources in
industries markets e.g. it often results in excess supply
Lowers prices & increases demand for merit when used in agricultural markets
goods There is an opportunity cost associated
Helps to change destructive consumer with the government expenditure - could the
behaviour over a longer period of time e.g. money have been better used elsewhere?
subsidising electric cars makes them Subsidies are prone to political pressure &
affordable and helps motorists to see them lobbying by powerful business interests e.g.
as an option for the masses - & not just the most oil companies receive subsidies from
elite their respective governments (despite
making $billions in profits each year)
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Other Government Policy Measures to Address Market Failure
Other Methods Used to Address Market Failure Your notes
Method Explanation Advantages Disadvantages
State Provision of Public goods are They are usually Paid for through
Public Goods beneficial for society & provided free at general taxation
are not provided by the point of There is an
private firms due to the consumption opportunity cost
free rider problem Accessible to associated with
Examples include roads, everyone their provision
parks, lighthouses, regardless of Products which are
national defence income free may result in
Usually provide both excess demand &
private & external long waiting times
benefits to society e.g. procedures at
Public hospitals
Privatisation Privatisation occurs Increases Government assets
when governments government are often sold well
transfer ownership & revenue in the year below their actual
control of firms/assets the asset is sold market value
from the State (public Private firms may run Private firms often
sector) to the private the business more provide a sub
sector (private firms) efficiently standard
Many State firms are The government no good/service as
monopolies. By longer needs to they cut quality to
privatising them it manage the increase profits
encourages more business or hire The price of the
competition in those people to work for good/service
markets it - this reduces usually increases as
This should result in more government firms seek to
efficiency & lower prices expenditure maximise their
for consumers profit e.g. energy
prices in the UK
market
Many privatised
companies still
maintain
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considerable
market power &
have to be Your notes
regulated, e.g. water
companies
Nationalisation Nationalisation occurs This can generate Government firms
when the Government efficiencies, can often run very
takes control & especially when inefficiently
ownership of firms which delivering utilities There is an
were in the private sector (gas, water, opportunity cost
electricity) to the associated with the
national population money required to
It creates more run it
equity in society as The Government
all citiz ens have the may lack the
same access to the expertise to run the
same resource at business
the same price e.g.
Norway
nationalised much
of the oil industry
when oil was first
discovered in 1972.
The profits belong
to the citiz ens
The business can
generate significant
revenue for
government
Regulation Governments create Individuals or firms Enforcing laws
rules to limit harm from may be requires the
the external costs of fined/imprisoned government to hire
consumption/production for breaking the more people to
They often create rules e.g. selling work for the
regulatory agencies to cigarettes to regulatory agencies
monitor that the rules are minors is a Enforcing laws can
not broken punishable offence be difficult as it is a
They help to reduce complex process to
the external costs determine if
of demerit goods firms/consumers
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Fines can generate are breaking the
extra government laws
revenue The regulation may Your notes
create
underground
(illegal) markets
which could
generate even
higher external
costs on society
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