There are a number of different economic systems with different approaches to organising the economy. 

1. Free market economy: Where markets allocate resources through the price mechanism. An increase in demand raises price and encourages businesses to use more resources into the production of that good or service. The quantity of products consumed by people depends on their income and income itself depends on the market value of an individual's work. In a free market economy there is a limited role for the government, indeed in a pure free market system, the government limits itself to protecting property rights of people and businesses using the legal system and protection the value of money or the value of the currency. 

1. Planned or command economy: Associated with a socialist or communist system, scarce resources are owned by the government. The state allocates resources, and sets production targets and growth rates according to its own view of people’s wants. Market prices play little or no part in informing resource allocation decisions and queuing rations scarce goods.
   

2. Mixed economy: In a mixed economy, some resources are owned by the public sector (government) and some are owned by the private sector. The public sector typically intervenes to prevent market failure and to provide public and merit goods 

The public sector is government owned and run. The private sector is privately owned and run (not run by the government). 

The public sector generally aim to maximise consumer welfare. The private sector aims to maximise profits. 

The public sector is important in reducing or eliminating market failure. 

Market failure occurs when the free market fails to allocate resources effectively. E.g. education tends to be under-consumed in the free market, therefore governments either subsidise or provide free at point of use. 

What is market failure?

Put very simply, market failure is when markets fail! I suppose the assumption is that if markets are working freely with no imperfections, this will give the most efficient outcome. What does that mean?

Well, if an economy is working well, firms will be producing at the lowest cost per unit possible (productive efficiency), the economy’s resources will be allocated between firms and industries in the most efficient way (allocative efficiency) and so the economy will be at a point on rather than within its production possibility frontier. To sum up, market failure occurs when an unregulated market does not achieve an efficient allocation of resources.

What are the main causes of market failure?

Now that we have established the circumstances under which markets are not failing, we need to look at the various reasons why markets do fail.

Remember, when we look at market failure, it is not just the nature of the failure that is important, but the market in question as well. For instance, most of you will be thinking about how product markets fail at the moment (I hope!), but labour market failure is a huge topic as well (covered in Theme 3).

Here are the three main causes of market failure:

1. Externalities

I hope you all recognise this word. Externalities can be positive or negative. An externality is something that is a by-product of a production process but affects a third party externally (the word from which ‘externality’ is derived). The classic example of a negative externality is pollution. A factory may pump loads of waste chemicals into a river as a result of their production process. This will negatively affect a third party; fisherman, for example, or a water company who will find it more difficult to filter the water. The key point is that no compensation is paid. If the factory realised what it was doing, cared (very unlikely), and paid for the water company’s loss, then the problem would be solved. Externalities can be positive as well. An individual derives benefit from education, but so does the rest of society through his increased productivity.

1. Public, merit and demerit goods

These are all types of goods where, if the government did not intervene, the market would under provide, over provide or even fail to provide at all. There is much more detail on this later on in this handout.

1. Information problems

In the real world, buyers and sellers do not have perfect information. A given restaurant may be half empty one evening and then have queues down the street the next. Ideally, they would like to be able to adjust their prices to allow for this, but they do not have the information beforehand to be able to do this (of course, there would be menu costs as well).

The first point to note is that public goods are not called public goods because they are provided by the public sector (i.e. the government). Although they do tend to be provided by the public sector, this is not the reason for the name!

All public goods have two important characteristics:

Non-excludability. A public good is one where it is impossible to exclude anyone from consuming it. I suppose this is why they are called public goods – they are open to the public!

Non-diminishability (non-rivalry). If, say, ten people are consuming a certain public good. The arrival of an eleventh person (who cannot be excluded) will not diminish the amount that the existing ten people can consume.

This all sounds a little confusing until we look at some examples. The best one is defence. Whether you like it or not, as a citizen of the UK you are defended by the army, the air force, the navy, etc. You cannot exclude yourself from being defended. Equally, if the UK experiences a period of net immigration, the new entrants will be defended, and their arrival does not diminish the amount by which you are being defended. You are either defended or not defended. You cannot be half defended!

The key point about public goods is that they are ‘good’ things, so they need to be provided, but because of these two characteristics, they have to be provided centrally, by the government.

Imagine that the government did not provide an army, navy, air force, etc. A private company might have the idea of forming a national army and to raise the required money, they decide to ask everyone for £10. If you did not want to be defended, then you would not pay. There may be a lot of people who refuse to pay for this reason. Also, there may be some people who do quite want to be defended, but take the risk of not paying on the assumption that there will be some people in the UK that will care enough to pay the inevitable increased price. This is the free-rider problem. The people who do not pay, for whatever reason, are having a free ride.

Anyway, this private company finds that their predicted revenues are not nearly enough to afford a full defence system, so they give up. The government can provide these goods because they can force people to pay through taxation and raise enough money to do the job properly. 

Another good example is street lighting. One cannot stop anyone from benefiting from a street light. Equally, the benefit that one person receives does not diminish the benefit of others. Again, if a private company tried to finance a set of street lights down a given road by knocking on the doors of the inhabitants of the street, lots of people would not pay relying on someone who cares enough to fork out for the amenity. So, again, governments (normally via local government) must provide street lighting. Textbooks often like to use the example of a lighthouse as well (think about it!).

To sum up, the reason why public goods come under the topic ‘Market failure’ is that the free market would fail, horribly, to provide defence and street lighting if left to themselves. The government has to intervene to correct this market failure. However, a car manufacturer can exclude someone from purchasing its cars if that person cannot afford it, which is why cars are classified as private goods.

Privatisation

Privatisation is the sale of government owned assets and industries to the private sector.