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Year 11 Economics 2022
11eco.6 – Market failure
Learning objectives for unit 6
Explain the concept of market failure with examples
Explain what is meant by positive and negative externalities, and asymmetric information, with
examples
Explain government policies to correct positive and negative externalities, including taxation and
subsidies, price controls, state provision, legislation and regulation and information provision
Evaluate the use and impact of government policies to address market failure
Limitations of markets
In a free market economy, the interaction of the forces of demand and supply results in a market
equilibrium which determines the allocation of resources. Any change in demand or supply leads to a
surplus or shortage and as a result price decreases or increases. The signalling/incentive functions of
price create a new equilibrium position.
An increase in demand causes the
demand curve to shift to the right and
both equilibrium price and quantity will
increase
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A decrease in demand causes the demand curve to shift to the left and both equilibrium price and quantity
will decrease
A decrease in demand causes the
demand curve to shift to the left and
both equilibrium price and quantity will
decrease
An increase in supply causes the
supply curve to shift to the right and
equilibrium price will decrease and
quantity will increase
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A decrease in supply causes the
supply curve to shift to the left and
equilibrium price will increase and
quantity will decrease
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Is the free market equilibrium the best outcome for society?
We sometimes assume that the market equilibrium must be a good outcome because the price is stable
and Qd = Qs. However, there many examples of markets where this is not the case. There may be
significant disadvantages resulting from a market in equilibrium.
Example – a free market in cigarettes (i.e. no taxation or restrictions on sales, advertising etc) would result
in a higher equilibrium quantity – leading to more premature deaths, disease, passive smoking, costs
on the health service.
Discussion point/Task 1
Explain why the free market equilibrium (no government intervention) may not be desirable in the
following cases:
Alcohol
Cycle helmets
Dairy farming
Covid-19 Vaccinations
Sugary drinks
Used car sales
Market failure
If the free market does not produce the best outcome for society, then market failure is said to occur.
Definition – market failure is a situation when the free market equilibrium is NOT the best outcome
for society.
Market failure
Externalities
One of the main reasons for market failure is the existence of externalities.
Definition - an externality is an unintended side-effect (spillover effect) on a 3 rd party as a result of
the production or consumption of a product
Externalities may be positive or negative, and may result from the production or consumption of a
product
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Externalities
What is a 3rd party?
When an economic transaction takes place, the seller (producer) is known as the 1st party while the buyer
(consumer) is the 2nd party. 3rd parties are those people not directly involved in the transaction.
Task 2: Add an example (of a 3rd party, and how they are affected) for each of the following
externalities
Type of externality Definition
Negative externality of A negative spill-over effect on 3rd parties resulting from the production of a
production good/service
e.g.
Positive externality of A positive spill-over effect on 3rd parties resulting from the production of a
production good/service
e.g.
Negative externality of A negative spill-over effect on 3rd parties resulting from the consumption of a
consumption good/service
e.g.
Positive externality of A positive spill-over effect on 3rd parties resulting from the consumption of a
consumption good/service
e.g.
Task 2a
Read the real-world examples below and identify the type of externality involved.
News extract Externality
Meat tax?
Commercial Aviation
Knee implants in India
Plastic bags
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Task 3 – complete the activities below
a) Who are the 3rd parties in the above diagrams? What economic activity is
affecting them? Are they affected positively or negatively?
Who are the 3rd parties? What are the externalities?
Air pollution from
factories b) For each of the situations below, identify the activity, the “third party” and the
spillover effect on the third party.
Pollution of New
Zealand waterways
Industrial waste
Noise pollution
Declining fish stocks
Methane emissions
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Who are the 3rd parties? What are the externalities?
Vehicle pollution
Household waste
Noise pollution
Air pollution
Traffic congestion
Gambling addiction
Litter from tourists
Spillover costs from
obesity
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Who are the 3rd parties? What are the externalities?
Health programmes
Early years
education
Subsidised bike
schemes in urban
areas
Public
libraries/community
spaces
Museums and
galleries
Free school meals
Vaccinations against
measles
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Asymmetric information
Another reason for market failure is a situation whether the seller and buyer of a product have different
information – so the information is “asymmetric”
Consider a used car showroom where a salesperson is trying to sell a car to a potential buyer. The seller
knows that the car had been in a bad crash two years ago but does not disclose this to the buyer. How/why
might this be considered to be a case of market failure?
Another example might be a school in which the marketing manager is showing parents and potential new
students around, but does not disclose that there have been several fights in the school in recent months.
Task 4
Discuss the examples and write a brief explanation below – how is the information “asymmetric”
and how does it affect the market equilibrium?.
Government Policies to address market failure
If the free market does not produce the best market outcome for society, then it is arguably the
role of the government to intervene in the market in order to influence the market outcome.
Negative externalities
Where negative externalities exist, the government may seek to reduce consumption/production of
the product or to reduce the externality itself (i.e. reduce the number of cigarettes smoked or
reduce the harmful particles which are in cigarette smoke)
Positive externalities
Where positive externalities exist, the government may seek to increase consumption/production
of the product or to increase the externality itself (i.e. increase the number of cycle helmets worn
or make each helmet safer)
Asymmetric information
The government might try to ensure that both parties have access to the information or make the
transaction invalid if one party does not disclose relevant information.
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Discussion/Task 5
In groups, brainstorm policies which a government could use to address the following externalities
Type of market failure Policies
Cigarette smoking
Vaccinations for measles
Life insurance – where applicants do not
fully disclose
Over-use of cars
Pollution from a coal-fired power station
Companies providing first-aid training for
their employees
Types of Government Policies
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Indirect taxation
Subsidies
Price controls
State provision
Provision of information (education/advertising)
Legislation and regulation
Type of policy Brief explanation and see previous unit: (government intervention)
for the mechanism of indirect taxes, subsidies and price controls)
Indirect taxation An indirect tax increases the costs of production, reducing profitability and
shifting the supply curve to the left – resulting in a higher price. As a result
the equilibrium quantity will decrease, thus reducing the externality. Also, a
tax could be imposed on the externality itself eg a carbon tax based on the
quantity of pollutants.
Subsidies A subsidy reduces the costs of production, increasing profitability and
shifting the supply curve to the right – resulting in a lower price. As a result
the equilibrium quantity will increase, thus increasing the externality. A
subsidy could also be used to increase production of a “better alternative”
to a harmful good (eg many governments have subsidised e-cars)
Price controls A minimum price could be used to make a product (with negative
externalities) less affordable, while a maximum price could be used to
make a product (with positive externalities) more affordable
State provision If the government wishes to ensure that a product is available for
everyone, it might provide the good/service free of charge and finance it
through taxation. e.g. education
Provision of Positive/negative information may be used to encourage/discourage
information consumers of a particular product. Advertisements about the dangers of
drink-driving, the harm done by smoking or the benefits of keeping fit are
intended to influence consumer behaviour accordingly.
Legislation and Legislation: laws to control the way people and organisations behave
regulation Regulations: rules, directives or government orders to control the way
people and organisations behave
Advertising cigarettes may be banned, or smoking in public places, age
restrictions etc may be put in place.
Task 6
Classify your examples (discussion only) from task 5 into one of the categories above (i.e. for each
policy you have chosen, state whether it is a price control, regulation etc…)
Evaluation of government policies to address market failure
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To evaluate means to make a judgment – to consider all the positive and negative aspects of a
policy and then make a judgment as to whether the policy is a good one, or whether there may be
better alternatives.
When required to evaluate a policy, you should:
Explain what the policy is
Explain how the policy is intended to work.
Draw a diagram to illustrate if you can
Explain the diagram
Consider some of the following aspects:
a. Is the policy likely to work? If not, then why not? How likely is it to work?
b. Does the policy have any disadvantages? How significant are these disadvantages?
c. How will different stakeholders be affected by the policy?
d. Is it practical? Could it be made to work or are their difficulties in enforcing the policy?
e. Is the policy fair? Who might think it is unfair? Do they have a strong case?
f. Might the policy have different effects on different people (eg young vs old). Does this
matter?
g. Might the policy have different effects in the short term and the long term? Does this
matter?
h. What can the government do to make the policy more effective?
And so……Should the policy be introduced?
Task 7
Select two market failure issues from the real-world examples below and make notes on the
evaluation of each one.
Philadelphia
Indonesia
China - special emissions limits
Scotland
Issue Policy Evaluation
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Assignment/Task 8
In 2021 the New Zealand government introduced the proposed “clean car rebate” policy which
was suggested in 2019? (also known as the “feebate”).
Research the issue and write an evaluative answer, with diagram(s) – 500 words max.
This relates to electric vehicles.
