EMPOWERING STUDENTS TO REACH THEIR PEAK POTENTIAL

J1 Microeconomics Set 4:
Types of Market Failure

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 Market Failure
Market failure occurs when the price mechanism, operating without any government
intervention, fails to utilize scarce resources to achieve efficient and equitable
outcomes.
What is efficiency and equity
• Efficiency refers to the Efficient allocation of resources refers to the allocation of
resources to produce the combination of goods and services most wanted by
society (i.e. allocative efficiency)
• Equity refers to fairness in the distribution of economic welfare usually in terms of
equal access to essential goods and services, such as education and healthcare
services.
Rational decision making by both consumers and producers can lead to efficient
allocation of resources in a perfectly competitive market.
Being rational agents, consumers will consume at the level of output where their
marginal private benefits (marginal utility), equals to their marginal private costs (cost
of consuming one more unit of the good), as this is the level of output where utility
(AIM) is maximized.

Being rational agents, producers at the level of output where their marginal private
benefit (marginal revenue), equals to their marginal private costs (marginal cost of
production), as this is the level of output where profit (AIM) is maximized.
Benefit/Cost/Price
Marginal Private Cost (MPC)

Marginal Private Benefit (MPB)

Quantity
Q1 Q3 Q2
Why do consumers/producers maximize their welfare at MPB=MPC?

• Before MPB=MPC (Q1), where MPB exceeds MPC, an additional unit of output
adds more to benefit than cost, hence the consumer/producer would want to
consume/produce more units of the good.
• After MPB=MPC (Q2), where MPC exceeds MPB, an additional unit of output
adds more to cost than benefit, hence the consumer/producer would want to
consume/produce less units of the good.
• At MPB=MPC (Q3), this is the last unit of output where as much as added to the
consumers benefit than to cost, and this is where the consumers/produce welfare
is maximized.

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 Positive Externalities
Positive Externalities are spill over benefits to third parties who are not directly
involved in the production/consumption of the good, and no payment for the benefit
is made.
1) 3 Step Contextual Analysis: Marginal Private, External and Social
Benefit of Resources
1. Identify Perpetrator & their Private Benefit:
Examples: Education: Ability of to earn higher income / Knowledge gained
Healthcare: Healthier bodies
2. Identify Third Party & their External Benefit:
Examples: Education: A higher skilled workforce translates to higher productivity
Healthcare: A healthier workforce translates to higher productivity
3. Identify the true benefit of resources to society = The Private benefit of
consuming/producing the good to perpetrator + External benefit to third party

S1 = MPC = MSC
Costs /
(Assuming no negative externalities)
Benefits MSC
MEB

MSB

MPB

O Output
Q1 Q2

2) 5 Step Graphical Analysis:

Assuming no negative externalities:
1. Divergence between Marginal Social Benefit and Marginal Private Benefit due to
Marginal External Benefit
2. Current Market Output (at Q1, where MPB=MPC), where consumer/producer
welfare is maximized
3. Social Optimal Level of Output (at Q2 where MSB=MSC), where society welfare is
maximized
4. Underconsumption/Underproduction results in resources misallocation
5. Deadweight loss is incurred (since every additional unit of output beyond current
market equilibrium adds more to benefit than cost, and more welfare can be
gained by increasing output), and the market fails to achieve allocative efficiency.

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 Negative Externalities
Negative Externalities are adverse spill over costs to third parties who are not
directly involved in the production/consumption of the good and no compensation is
involved.
1) 3 Step Contextual Analysis: Marginal Private, External and Social
Cost of Resources
1. Identify Perpetrator & their Private Cost/Benefit:
Examples: Factories (Production): Cost of production
Cars (Consumption): Fuel/time cost
2. Identify Third Party & their External Cost/Benefit:
Examples: Factories: affected by uncompensated health costs due to pollution
Cars: congestion to other motorist or health cost due to pollution
3. Identify the true cost of resources to society = The Private cost of
consuming/producing the good to perpetrator + External cost to third party

MSC
Costs /
Benefits MEC
MPC

D1 = MPB = MSB
(Assuming no positive externalities)

O Output
Q2 Q1

2) 5 Step Graphical Analysis:

Assuming no positive externalities:
1. Divergence between Marginal Social Cost and Marginal Private Cost due to
Marginal External Cost.
2. Current Market Output (at Q1, where MPB=MPC), where consumer/producer
welfare is maximized
3. Social Optimal Level of Output (at Q2, where MSB=MSC), where society welfare
is maximized
4. Overconsumption/Overproduction results in resources misallocation
5. Deadweight loss is incurred (since every additional unit of output beyond socially
optimal level adds more to cost than benefit, and more welfare can be gained by
reducing output), and the market fails to achieve allocative efficiency.
Possible additional evaluation (Only for Negative externalities questions):
Assumption is that there are no positive externalities in production/consumption.
However, there could potentially be positive externalities (EG: production can lead to
industrialization, job creation and higher income.) Therefore, problem of
overproduction is less serious.

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 Merit/Demerit Goods
Merit goods are goods deemed to be socially desirable by the government while
Demerit goods are goods deemed to be socially undesirable by the government.
Merit goods are often under-consumed by consumers and Demerit goods are often
over-consumed by consumers due to imperfect information and ignorance.
When talking about Merit Goods, two types of market failure that occur are imperfect
information and positive externalities.
When talking about Demerit Goods, two types of market failure that occur are
imperfect information and negative externalities.
What is imperfect information?
• Individuals or firms lack information that is required for them to make economic
decisions. In perfectly competitive markets, consumers and firms have perfect
information (perfect knowledge about prices, costs and benefits of goods and
services).
• However, in the real world, there is imperfect information that causes a great deal
of ignorance and uncertainty.
• Producers/consumers may be unaware of the true costs and benefits of
consuming/ producing a good and thus do not consume at the social optimal level.

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 Merit Goods: Imperfect Information
1) Identifying Perceived vs Actual Benefit
1. Identify the Perceived Benefit of the consumer:
Examples: Consuming Healthcare can help cure existing health problems

2. Identify the Actual Benefit of the consumer:

Examples: Healthcare can also help prevent future problems by identifying
symptoms early, and the consumer’s ignorance causes consumers to
undervalue healthcare.

3. Identify that the difference between Actual and Perceived Benefit leads to
Marginal Benefit of consuming the good being lower than it should be

Costs /
Benefits
MSC MPC

MPBactual

MPBperceived

Output
O
Q1 Q2

2) 5 Step Graphical Analysis:

1. Identify that consumer perceived benefit is MPBperceived, but actual benefit is at
MPBactual, which is higher than MPBperceived
2. Current Market Output (MPBperceived=MPC), the level of output where
consumer/producer perceives that their welfare is maximized
3. Social Optimal Level of Output (MPBactual=MSC), the level of output where
consumer/produce welfare is actually maximized
4. Underconsumption results in resources misallocation
5. Deadweight loss is incurred (since every additional unit of output beyond current
market equilibrium adds more to benefit than cost to the consumer/producer, and
more welfare can be gained by increasing output), and the market fails to achieve
allocative efficiency.

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 Demerit Goods: Imperfect Information
1) Identifying Perceived vs Actual Cost
1. Identify the Perceived Cost of the consumer:
Examples: Consuming cigarettes will cost the consumer the money paid for the
box of cigarettes and the lighter

2. Identify the Actual Cost of the consumer:

Examples: Cigarettes are harmful to the body and can cause diseases such as
lung cancer, and the consumer’s ignorance causes consumers to
overvalue cigarettes.

3. Identify that the difference between Actual and Perceived Cost leads to Marginal
Cost of consuming the good being lower than it should be

MPCactual
Costs /
Benefits
MPCperceived

MPB

O Output
Q2 Q1

2) 5 Step Graphical Analysis:

1. Identify that the consumer perceived cost is MPCperceived, but actual cost is at
MPCactual, which is higher than MPCperceived
2. Current Market Output (MPB=MPCperceived), the level of output where
consumer/producer perceives that their welfare is maximized
3. Social Optimal Level of Output (MPB=MPCactual), the level of output where
consumer/produce welfare is actually maximized
4. Overconsumption results in resources misallocation
5. Deadweight loss is incurred (since every additional unit of output beyond socially
optimal level adds more to cost than benefit to the consumer/producer, and more
welfare can be gained by decrease output), and the market fails to achieve
allocative efficiency.

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 Market Failure: Public Goods
Complete market failure occurs in the market for public goods since no resources
are diverted towards the production of such goods. Public goods are defined as
goods that are non-rivalrous and non-excludable in consumption. These two inherent
characteristics results in the market being said to be “missing”.
1) Non-rivalrous
A good is non-rivalrous when consumption of the good does not reduce the amount
left for others to consume. In other words, the satisfaction of other users is not
diminished when another user uses the good.
• EG: Street lighting is non-rivalrous in consumption since the amount of lighting
available to a pedestrian or driver does not diminish after another individual has
made use of the street.
• Being non-rivalrous in consumption means that the supply of street lighting does
not diminish with an additional consumer. Hence, the marginal cost of producing
street lighting is zero, indicating that the opportunity cost of having another user
consume the good is virtually zero.
• Since Allocative efficiency is achieved when Price = Marginal Cost, the price
charged for the good must be zero for AE to be achieved. Since a rational
producer is profit motivated, he is unwilling to supply the good at zero price,
leading to zero/missing supply for the good.
2) Non-excludable
A good is non-excludable when it’s not possible or prohibitively costly to exclude
non-payers from consuming the good once it has been produced.
• EG: Street lighting is non-excludable since it is impossible to exclude pedestrians
or drivers from enjoying an illuminated street even if they are non-payers.
• Once a good is provided, it is impossible from preventing non-payers from
enjoying the similar benefits of the good. Profit-motivated firms are unwilling to
supply the good due to lacking the ability to charge all consumers a price.
• This results in the free rider problem. People want to enjoy the benefits of the
good but are not willing to pay since they are not excluded from the benefits even
if they refuse to pay. Thus, the demand is concealed, and the consumers’
preference is not indicated by the price signals.
Hence, complete market failure occurs since profit-motivated producers will not be
willing to supply the good and demand is concealed due to the free rider problem,
leading to market forces failing to allocate resources efficiently. This results in a
“missing” market, due to the absence of price signals leading to zero production
of the good. Since resources are not efficiently allocated to the production of a good
desired by the society, this will result in market failure. In such cases, government
intervention in the form of free public provision is required.
Comparing to private goods (merit/demerit):
• Rivalrous: Once [a private good] is consumed, another user is unable to enjoy the
good, hence their satisfaction is diminished, and there is an opportunity cost of
consuming the good in contrast to a public good like [streetlights]
• Excludable: Once [a private good] is consumed, it is possible to prevent another
user from enjoying the good without paying for the good, hence firms will be
willing and able to supply the good.

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