Market Failure
Write down everything
that comes to mind when
you think “Market
Failure”.
Market Failure
We’ve learned what the market
should do when it operates perfectly.
Signalling
Incentives
Rationing
Allocatin
g
Signalling
Market failure happens when
the price mechanism fails to
allocate scarce Incentives
resources efficiently or
when the operation of market Rationing
forces lead to a net social
welfare loss
Allocatin
g
In essence, the market is ‘failing’ to bring about either:
1. An efficient allocation of resources
2. An equitable (fair) allocation of
resources
Market failure
It’s important to understand that many markets suffer from market failure.
Like other concepts, markets are never as good as expected.
Partial Complete
market market
failure failure
Under or over Missing markets
production /consumption
NOTHING AT
TOO MUCH TOO ALL
LITTLE
A market is more
complicated than
just supply and
demand. There
are “external”
factors to
consider.
Why does market failure matter?
Market failure matters because it
reduces the potential level of welfare in
the economy.
In other words market failure causes a
deadweight loss to society.
(Remember, a central part of economics
is the assumption that we aim to
maximise utility/welfare)
Types of market failure
1. Negative externalities in 1. Demerit goods
production 2. Other Information
2. Negative externalities in failures
consumption 3. Monopolies (A2)
3. Positive externalities in 4. Factor immobility
production
5. Moral hazard
4. Positive externalities in
consumption 6. Inequalities in the
distribution of
5. Public goods income & wealth
6. Merit goods (A2)
https://www.youtube.com/watch?v=CuJ4E1UMk3c
Externalities
The external ‘spill-over’ consequences of production or
consumption of a good. They can be positive or negative.
Externalities are the costs or benefits that are
external to the initial production/consumption of a
good.
As the impacts spill-over from the original producer
or consumer, others feel these impacts without
making a choice to do so.
The original producer/consumer does not include This is the
the external impacts in their private assessments of market failure
the benefits and costs, and therefore neither does
the market.
Pair work: Spot the externalities
If driving is the activity, what are the positive and negative externalities?
Are these externalities in CONSUMPTION or PRODUCTION? Do you think the drivers care about these
Benefits and costs
Marginal Private Benefit (MPB): Marginal Private Cost (MPC): the
the additional benefit of consuming or additional cost of consuming or
producing an extra unit to individuals or producing an extra unit to individuals and
firms.
Only the external costs and benefits are the
firms, this could be financial or less
externalities....
e.g. the profit made by using electricity to tangible such as to reputation
power a factory e.g. the cost of buying the electricity from
the supplier
Marginal External Benefit (MEB): Marginal External Cost (MEC):
the additional benefit of consuming or the additional cost of consuming or
producing an extra unit to those around producing an extra unit to those around
you or more widely, society you or more widely, society
e.g. new factory will bring new jobs e.g. negative effects of pollution
1b. -ve Externalities in Consumption
Occurs when consumers impose a cost (-
ve benefit) onto others when they
consume goods/servicesThe MPB>MSB
Benefits and costs
Marginal Private Benefit (MPB): Marginal Private Cost (MPC): the
the additional benefit of consuming or additional cost of consuming or
producing an extra unit to individuals or producing an extra unit to individuals and
firms. firms, this could be financial or less
tangible such as “reputation”.
Write down the marginal Write down the marginal
private benefits of a car private costs of a car owner.
owner.
Externality of Consumption: This is graph is from the perspective
of the consumer!
Price/
Cost/
Benefit
S = MPC
P
1
D=
MPB
Q Quantit
1
y
Note down the marginal external costs and marginal external benefits of
driving a car.
Marginal External Benefit (MEB): Marginal External Cost (MEC):
the additional benefit of consuming or the additional cost of consuming or
producing an extra unit to those around producing an extra unit to those around
you or more widely, society you or more widely, society
e.g. new factory will bring new jobs e.g. negative effects of pollution
Are there more benefits or costs? If society took these into account would they consume more
or less cars?
Are there more benefits or costs? If society took these into account they WOULD DEMAND LESS
CARS!
PB + (-ve)EB = SB
The private benefit plus the cost
imposed onto others (the -ve external
benefit) is equal to the true benefit to
society (the social benefit)
However, in this case we are consuming more than society
would like us to!
This is what we want to
Optimum output consider. The social optimum
is when the private and
external costs/benefits are
combined...
Private
Cost + Externa
l Cost = Social
Cost
Private
Benefit + Externa
l = Social
Benefit
Benefit
The market only considers the private (internal)
costs and benefits when deciding optimum output.
The market ignores the external costs/benefits (the
externalities), and therefore fails to take account the
true costs & benefits to society.
Notice the externality is slanted due to the proportional increase / decrease of the
externality.
PB + (-ve)EB = SB
Example:
Driving a car 10 miles
PB = Convenience, speed of travel, comfort = £2.00
-ve EB = Congestion & pollution = 50p
SB = £1.50
Driving a car 100 miles
PB = Convenience, speed of travel, comfort =
£20.00
-ve EB = Congestion & pollution = £5.00
SB = £15.00
The greater the number of miles, the greater
the difference between the PB and the SB
Notice the
externality is
Price/ slanted due to the
Cost/ proportional increase /
Benefit decrease of the
externality.
S = MPC =
MSC
-ve
MEB
-ve ext
P Deadweight
1 loss to
P society
2
-ve D=
MEB
MSB MPB
Use different colours -ve
ext
if it helps.
Q Q Quantit
2 1
y
Welfare loss
Price
MPC = MSC
TIP:
The deadweight welfare loss
triangle ALWAYS points towards P1 Deadweight
the social optimum equilibrium welfare loss
P2
(MSB=MSC).
(and points away from the
original output level, Q1) MPB
It is the difference between the MSB
MSC & MSB at the free market Q2 Q1 Quantity
equilibrium
-ve externalities in consumption cause market failure
because:
If left to the free market consumers only take into account their own
private costs & benefits.
Because of the existence of a -ve externality:
MSB<MPB (-ext in consumption) (the MSB curve lies below
the MPB curve and the vertical distance between the two is the
size of the MEC/-ve externality/-ve benefit)
Therefore we consume/ produce where MPC=MPB at P1, Q1
This is the free market equilibrium
However, the social optimum level of output is where MSC=MSB at
P2, Q2
Therefore goods which display -ve externalities in consumption are
OVER-CONSUMED/ OVER-PRODUCED
This means that TOO MANY SCARCE RESOURCES are being used
to produce this good.
Therefore we have a MISALLOCATION of SCARCE RESOURCES.
We are not allocating our scarce resources to produce the quantity of
goods that society wants
Therefore, we are ALLOCATIVELY INEFFICIENT – i.e. the market has
FAILED to bring about allocative efficiency
Negative externalities in consumption – Cars
https://www.youtube.com/watch?v=qGgBoEpLQdQ
Do we agree that cars need to go?
Another one: https://www.youtube.com/watch?
1. –ve externalities
Negative externalities
Definition: A -ve externality is a cost
imposed onto a third party by the
action/decision of others.
A -ve externality is also known as an
external cost or a negative benefit
The market failure occurs because when a
decision is made only the private cost is
considered whereas the full cost to society
(the social cost) should be considered.
This leads to over-consumption & a
misallocation of scarce resources.
1 - Negative externalities in
production2 - Negative
externalities in consumption
Copy into notes
-ve Externalities in ProductionOccurs when
producers impose a cost onto others through
their production processesThe MPC<MSC
https://www.youtube.com/watch?v=8VvqK1JRTuA
Until 02:30
Marginal = extra _____ for each
unit
Marginal Benefit & Cost
In the free market,
Price
The demand curve shows us the goods are allocated Supply =
utility or benefit gained from each to the point of MPC
additional unit consumed. MPB=MPC
The demand curve = Marginal
Private Benefit (MPB)
P1
The supply curve shows us the cost
incurred from each additional unit
produced.
Demand
The supply curve = Marginal Private = MPB
Cost (MPC)
Q1 Quantity
Benefits and costs
Marginal Private Benefit (MPB): Marginal Private Cost (MPC): the
the additional benefit of consuming or additional cost of consuming or
producing an extra unit to individuals or producing an extra unit to individuals and
firms. firms, this could be financial or less
tangible such as reputation
Write down the marginal Write down the marginal
private benefits of the paper private costs of the paper
factory. factory.
Externality of Production: This is graph is from
the perspective of the producer!
Price/
Cost/
Benefit
S = MPC
P
1
D=
MPB
Q Quantit
1
y
Note down the marginal external costs of the paper factory.
Marginal External Benefit (MEB): Marginal External Cost (MEC):
the additional benefit of consuming or the additional cost of consuming or
producing an extra unit to those around producing an extra unit to those around
you or more widely, society you or more widely, society
e.g. new factory will bring new jobs e.g. negative effects of pollution
Would society want the firm the produce more or less paper?
PC + EC = SC
(MPC + MEC = MSC)
The private cost plus the cost
imposed onto others (the external
cost) is equal to the true cost to
society (the social cost)
DO NOT confuse the
EXTERNAL COST with the SOCIAL
COST
If the firm took these into account they WOULD PRODUCE LESS PAPER!
PC + EC = SC
The private cost plus the cost imposed
onto others (external cost) is equal to
the true cost to society (the social
cost)
However, in this case we are producing more than society
would like us to!
This is what we want to
Optimum output consider. The social optimum
is when the private and
external costs/benefits are
combined...
Private
Cost + Externa
l Cost = Social
Cost
Private
Benefit + Externa
l = Social
Benefit
Benefit
The market only considers the private (internal)
costs and benefits when deciding optimum output.
The market ignores the external costs/benefits (the
externalities), and therefore fails to take account the
true costs & benefits to society.
Why is the
Price/
MSC externality slanted?
Cost/
Benefit
S = MPC
MEC
P -ve
ext
2
P
1
MEC
-ve
ext D = MPB =
MSB
MPB
Q Q Quantit
2 1
y
Use different colours
if it helps.
PC + EC = SC
Example:
Burning coal to make a small amount of electricity
PC = Wages, coal = £200
EC = Congestion & pollution = £10
SC = £210
Burning coal to make a large amount of electricity (2500
times as much)
PC = Wages, coal = £500,000
EC = Congestion & pollution = £25,000
SC = £525,000
The greater the amount of coal burned, the greater the
difference between the PC and the SC (i.e. the greater the
size of the externality)
Where does our deadweight welfare loss go? Notice the
externality is
Price/ slanted due to the
MSC
Cost/ proportional increase /
Benefit decrease of the
externality.
S = MPC
MEC
P -ve Deadweight
ext
2
loss to
P
society
1
MEC
-ve
ext D = MPB =
MSB
MPB
Use different colours
if it helps.
Q Q Quantit
2 1
y
-ve externalities inproduction
cause market failure because……
If left to the free market, firms only
take into account their own private
costs & private benefits.
Because of the existence of a -ve
externality the MSC>MPC (the MSC
curve lies above the MPC curve and
the vertical distance between the
two is the size of the MEC)
Therefore we choose to produce
where MPC=MPB at P1, Q1
This is the free market equilibrium
However, the social optimum level
of output is where MSC=MSB at P2,
Q2
Therefore goods which display –ve
externalities in production are OVER-
CONSUMED & OVER-PRODUCED
This means that TOO MANY SCARCE
RESOURCES are being used to produce
this good.
Therefore, we have a MISALLOCATION of
SCARCE RESOURCES.
We are not allocating our scarce resources
to produce the quantity of goods that
society wants
Therefore, we are ALLOCATIVELY
INEFFICIENT – i.e. the market has
FAILED to bring about allocative
efficiency/ to allocate scarce
resources efficiently
Research as many examples as you can of
current or past specific examples of negative
externalities in production and consumption.
Write short (but specific) overviews of the
cases found.I will ask you to share your
findings with the class.
1. Draw a negative externality in
consumption diagram
Starter Qsfrom memory
and compare to the one in your notes
after.
2. Draw a negative externality in
production diagram from memory and
compare to the one in your notes after.
ExternalitiesThe effect
on a 3 party due to
rd
consumption or
production of a
good/service.
Tim Berners-Lee
Positive externalities – James Dyson
https://
www.youtube.com/
watch?
v=9GWzWehxels&t=337
s
1 - Positive externalities in
production2 - Positive
externalities in consumption
+ve externalities
Positive externalities Copy into notes
Definition: A +ve externality is a benefit
imposed onto a third party by the
action/decision of others.
A +ve externality is also known as an
external benefit
The market failure occurs because when a
decision is made only the private benefit is
considered whereas the full benefit to society
(the social benefit) should be considered.
This leads to under-consumption & a
misallocation of scarce resources.
Copy into notes
+ve Externalities in ConsumptionOccurs when
consumers impose a benefit onto others when they
consume goods/servicesThe MPB<MSB
Benefits and costs
Marginal Private Benefit (MPB): Marginal Private Cost (MPC): the
the additional benefit of consuming or additional cost of consuming or
producing an extra unit to individuals or producing an extra unit to individuals and
firms. firms, this could be financial or less
tangible such as to reputation
Think of the marginal private Think of the marginal private
benefits of being vaccinated costs of being vaccinated
+ve externalities in consumption
Price/ Externality of Consumption: This is graph is from
Cost/ the perspective of the consumer!
Benefit
S = MPC
P
1
D=
MPB
Q Quantit
1
y
What’s the main marginal external benefit of being vaccinated.
Marginal External Benefit (MEB): Marginal External Cost (MEC):
the additional benefit of consuming or the additional cost of consuming or
producing an extra unit to those around producing an extra unit to those around
you or more widely, society you or more widely, society
e.g. new factory will bring new jobs e.g. negative effects of pollution
Would society want people to consume more or less vaccines?
If the people took this into account then WE WOULD CONSUME MORE VACCINES!
PB + EB = SB
The private benefit plus the benefit
imposed onto others (external benefit)
is equal to the true benefit to society
(the social benefit)
in this case we are consuming less than society would like us
to!
This is what we want to
Optimum output consider. The social optimum
is when the private and
external costs/benefits are
combined...
Private
Cost + Externa
l Cost = Social
Cost
Private
Benefit + Externa
l = Social
Benefit
Benefit
The market only considers the private (internal)
costs and benefits when deciding optimum output.
The market ignores the external costs/benefits (the
externalities), and therefore fails to take account the
true costs & benefits to society.
PB + EB = SB
Example:
Vaccination
If a +ve externality in consumption
exists then:
PB<SB
+ve externalities in
Price/
Cost/
consumption
The deadweight welfare loss triangle ALWAYS points
towards the social optimum equilibrium
Benefit
Deadweight
loss to S = MPC =
society MSC
P
2
P
1
MSB
Notice the
externality is
D = MPB
slanted due to the
MPB
Use different colours proportional increase /
if it helps. decrease of the
Q Q
Quantit externality.
2
1
Under- y
consumption/
production
+ve externalities in consumption cause
market failure because……
If left to the free market we only take into
account our own private costs & benefits.
Because of the existence of a +ve
externality:
MSB>MPB (+ext in consumption)
Therefore we consume/ produce where
MPC=MPB at P1, Q1
However, the social optimum level of
output is where MSC=MSB at P2, Q2
Therefore goods which display +ve
externalities in consumption are UNDER-
CONSUMED/ UNDER-PRODUCED
This means that NOT ENOUGH SCARCE
RESOURCES are being used to produce
this good.
Therefore we have a MISALLOCATION of
SCARCE RESOURCES.
We are not allocating our scarce resources
to produce the quantity of goods that
society wants
Therefore we are ALLOCATIVELY
INEFFICIENT
Copy into notes
+ve Externalities in ProductionOccurs when
producers impose a benefit (lower costs) onto others
through their production processesThe MPC>MSC
Benefits and costs
Marginal Private Benefit (MPB): Marginal Private Cost (MPC): the
the additional benefit of consuming or additional cost of consuming or
producing an extra unit to individuals or producing an extra unit to individuals and
firms. firms, this could be financial or less
tangible such as to reputation
Think of the marginal private Think of the marginal private
benefits of new inventions costs of new inventions
+ve externalities in production
Price/ Externality of Production: This is graph is from
Cost/ the perspective of the producer!
Benefit
S = MPC
P
1
D=
MPB
Q Quantit
1
y
What’s the main marginal external benefit (-ve external cost) of new
inventions.
Marginal External Benefit (MEB): Marginal External Cost (MEC):
the additional benefit of consuming or the additional cost of consuming or
producing an extra unit to those around producing an extra unit to those around
you or more widely, society you or more widely, society
e.g. new factory will bring new jobs e.g. negative effects of pollution
Would society want people to produce more or less of these inventions?
If the people took this into account then WE WOULD PRODUCE MORE INNOVATIVE
PRODUCTS!
PC + (-ve)EC = SC
The private cost plus the benefit
imposed onto others (the -ve external
cost) is equal to the true cost to
society (the social cost)
in this case we are producing less than society would like us
to!
This is what we want to
Optimum output consider. The social optimum
is when the private and
external costs/benefits are
combined...
Private
Cost + Externa
l Cost = Social
Cost
Private
Benefit + Externa
l = Social
Benefit
Benefit
The market only considers the private (internal)
costs and benefits when deciding optimum output.
The market ignores the external costs/benefits (the
externalities), and therefore fails to take account the
true costs & benefits to society.
PC + -ve EC = SC
Example:
The Internet
If a +ve externality in production
exists then:
SC<PC
+ve externalities in
Price/
Cost/
production
The deadweight welfare loss triangle ALWAYS points
towards the social optimum equilibrium
Benefit Notice the
externality is
S = MPC slanted due to the
Deadweight proportional increase /
loss to decrease of the
society externality.
MSC
P
1
P
2
D = MPB =
MSB
MPB
Use different colours
if it helps.
Q Q
Quantit
2
1Under-
y
consumption/
production
+ve externalities production causemarket
failure because……
If left to the free market we only take into
account our own private costs & benefits.
Because of the existence of a +ve
externality:
MSC<MPC (+ext in production)
Therefore we consume/ produce where
MPC=MPB at P1, Q1
However, the social optimum level of
output is where MSC=MSB at P2, Q2
Therefore goods which display +ve
externalities in production are UNDER-
CONSUMED/ UNDER-PRODUCED
This means that NOT ENOUGH SCARCE
RESOURCES are being used to produce
this good.
Therefore we have a MISALLOCATION
of SCARCE RESOURCES.
We are not allocating our scarce
resources to produce the quantity of
goods that society wants
Therefore we are ALLOCATIVELY
INEFFICIENT
Task 1: From the above pictures
find examples of: Task 2: What are the Task 3: Private vs. Social
Negative externalities in names for these labels Benefits and Costs
productionNegative on a graph? Private + External = Social
-VE = Match these differences
externalities in consumption
+VE = between private and social
Positive externalities in MPC = costs/benefits to the correct
productionPositive MSC = externality.
externalities in consumption MPB = MSC>MPC
Think about the point when MSB = MSC<MPC
the externality actually takes MEB = MSB>MPB
place! MEC = MSB<MPB
From the above pictures find What are the names for Private vs. Social Benefits and
examples of: these labels on a Costs
Negative externalities in graph? Private + External = Social
productionNegative -VE = Negative -ve ext. in prod:
+VE = Positive MSC>MPC
externalities in consumption MPC = Marginal Private
Positive externalities in +ve ext. prod:
Cost
MSC<MPC
productionPositive MSC = Marginal Social
Cost +ve ext. cons:
externalities in consumption MSB>MPB
MPB = Marginal Private
Think about the point when Benefit -ve ext. in cons:
the externality actually MSB = Marginal Social MSB<MPB
takes place! Benefit
MEB = Marginal External
Draw a negative externality in
Plenary Qs
1.
consumption diagram from memory
and compare to the one in your notes
after.
2. Draw a negative externality in
production diagram from memory and
compare to the one in your notes after.
3. Draw a positive externality in
production diagram from memory and
compare to the one in your notes after.
4. Draw a positive externality in
consumption diagram from memory
and compare to the one in your notes
after.
EXTRAS
Read Model
Answers Booklet
– Negative
Externalities in
Consumption
10 - 15 Minutes Prep
Time
Let’s Try This Question On
Cars
For a 15 mark question you
should spend around 25
minutes on it.
We will have time now to
prepare:
What is the question is
asking, identify private /
external costs and benefits,
decide what externality
Negative externalities in consumption – Cars
https://www.youtube.com/watch?v=rSSNlM3Au1A
PEER MARKING w/
model answer
Swap with
someone else and
read their answer
– (don’t write on
it).
Place them within
one of the bands
1 – 3.
Explain to them
why you’ve put
them there.
1b. -ve Externalities in
ConsumptionOccurs when
consumers impose a cost (-
ve benefit) onto others
when they consume
goods/servicesThe
MPB>MSB
PB + (-ve)EB =
SB
This leads to over-consumption & a misallocation of scarce
-ve Externalities in
Consumption
How to structure your
written answer – Part 1
-ve Externalities in
Consumption
How to structure your
written answer – Part 2
-ve Externalities in
Consumption
How to structure your
written answer – Part 3
+ve Externalities in ConsumptionOccurs
when consumers impose a benefit onto others
when they consume goods/servicesThe
MPB<MSB
MPB + MEB =
MSB
This leads to under-consumption & a misallocation of scarce
resources.
+ve Externalities in
Consumption
How to structure an answer - Part 1
+ve Externalities in
Consumption
How to structure an answer - Part 2
+ve Externalities in
Consumption
How to structure an answer - Part 3
+ve Externalities in ProductionOccurs when producers
impose a benefit (lower costs) onto others through their
production processesMPC + (-ve)MEC = MSCThe MPC>MSC
+ve Externalities in
Production
How to structure an answer - Part 1
+ve Externalities in
How toProduction
structure an answer - Part 2
+ve Externalities in
How to Production
structure an answer - Part 3
-ve Externalities in
ProductionOccurs when
producers impose a cost
onto others through their
production processesThe
MPC<MSC
(MPC + MEC =
MSC)
This leads to over-consumption & a misallocation of scarce
resources.
-ve Externalities in
Production
How to structure your written answer – Part 1
-ve Externalities in
Production
How to structure your written answer – Part 2
-ve Externalities in
Production
How to structure your written answer – Part 3
Examples of goods which display Example on the
externalities in production or consumption whiteboard…
1. Draw diagrams for each of the scenarios in your table and state:
2. Is it positive or negative?
3. Is it an externality in Production or Consumption?
4. What are the Private Costs and Benefits
5. What is the External Cost OR Benefit.
6. Is there an under or over consumption of this good.
Extension – Do this for any others: Driving, Internet, Dyson, Free school meals, workplace
training, free healthcare, travel bursary, talking to friends in class all the time…
Market Failure Basic Overview (And
Government Intervention)
https://www.youtube.com/watch?
v=13JOGWzY8kE&t=541s
