Ch 9 - Market Failure 

Market failure occurs when resources aren’t allocated in an optimal manner, meaning

that the market isn’t allocatively efficient, and community surplus isn’t maximized.

Types of goods:

1. Demerit goods are goods or services considered to be harmful to people who consume

them and to society as a whole, that would be over-provided by the free market and so

over-consumed.

2. Merit goods are goods or services considered to be beneficial for people who use them

and society as a whole, that would be under-provided by the free market and so under-

consumed.

• Tradable permits is a market-based solution to negative externalities of production. They

are permits to pollute, issued by government, which sets a maximum amount of pollution

allowable. Firms may trade these permits for money.

3. Public goods are goods or services which would be under-provided or not provided at all

by the free market. They are non-excludable and non-rivalrous, making it pointless for

private individuals to provide the good themselves.

• Sustainability/Sustainable development is where consumption needs of the present

generation are met without reducing the ability to meet the needs of future generations

Private cost: cost on you, as a consumer

Private benefit: benefit for you, as a consumer

External cost: cost on other people because of you

External benefit: other people’s benefit because of you

Social cost: private and external cost

Social benefit: private and external benefit

Marginal social cost (MSC): total cost society pays for the production of another unit of taking further action in the economy

• Total cost is calculated as:
• MPC = marginal private cost
• MEC = marginal external cost (+ive,-ive)

Marginal social benefit (MSB): individuals social benefit, plus overall benefit to society from one additional unit of production

• Includes positive and negative externalities that impact individual societies
• MSB = MPB + external benefit

Externalities: when a production or consumption of a good has an effect on third party occurrence

• Actions that have a -ive or +ive effect on others

Negative Externalities: are the ‘bad’ effects that are suffered by the third party, for which

the third party doesn’t get compensated, when a good or service is produced or

consumed

1. Negative externalities of production and consumption
2. MSC>MPC
3. MSC = MPC + MEC

• negative externalities of consumption: occur when the consumption of a good or service creates the external costs that is damaging to third parties (MSB<MPB)
• Negative externalities of production: occur when the production of a good or service creates external costs that are damaging to third parties (MSC>MPC).

Positive Externalities: are the beneficial effects that are enjoyed by a third party, but not paid for by the third party, when a good or service is produced or consumed

1. positive externalities of production and consumption
2. MSB > MPB

• Positive externalities of production: occur when the production of a good or service creates external benefits for third parties (MPC>MSC).
• Positive externalities of consumption: occur when the consumption of a good or service creates external benefits for third parties (MSB>MPB).

Externalities inefficiency:

1. Market may not maximise total surplus
2. When externalities in the free market result in less efficiency private benefits/costs which are not equal to social benefit/costs