Key Terms
Market failure: Where the market fails to produce what consumers require at the lowest possible cost.
Partial market failure: Where the free market provides a product but with a misallocation of resources e.g. merit goods
Externalities: Costs or benefits that spill over to third parties external to a market transaction.
Positive externalities: A positive spill over effect to third parties of a market transaction.
Negative externalities: Costs imposed on a third party, not involved with the consumption or production of the good.
Partial market failure: Where the free market provides a product but with a misallocation of resources e.g. merit goods
Externalities: Costs or benefits that spill over to third parties external to a market transaction.
Positive externalities: A positive spill over effect to third parties of a market transaction.
Negative externalities: Costs imposed on a third party, not involved with the consumption or production of the good.
Theory
Sources of Market Failure
Positive Externalities
Positive externalities in production
The production of a merit good will have a positive spillover effect to third parties thus causing a positive externality to arise.
For example the production of catalysts in cars will reduce pollution, making cleaner air for society and increasing life expectancy.
Positive externalities in consumption
The consumption of a merit good by one consumer will have additional positive effects on the rest of society. For example if one person consumes a vaccination for an illness, then all those around that consumer will benefit as they are less likely to catch the illness.
Negative Externalities
Negative externalities in production
The production of a good may also have harmful effects to third party society. For example the production of an airport may cause both air pollution and aesthetic pollution.
Negative externalities in consumption
The consumption of demerit goods by one consumer may also have negative third party effect on society. For example the consumption of alcohol may have negative effects on society in the form of violent behaviour or drink driving.
Imperfect Information (merit goods / demerit goods)
Individuals may not act in their best interests as they have imperfect information of the benefits that can be derived.
Demerit goods
Demerit goods also suffer failure of information. Consumers are unaware of the long-term damage to their own health.
Public Goods
A good that posses the characteristics of non-excludability and non-rivalry in consumption is a public good.
1) Non-excludability: Those that do not pay can still enjoy the benefits of consumption for no financial cost.
2) Non-rivalry: Consumption of a public good by one person does not reduce the availability of a good to others.
Quasi-public Goods
A good that has some qualities of a public good but does not fully possess the two required characteristics of non-rivalry and non-excludability is considered a quasi-public good.
Example: National parks such as the Lake District
National parks are open to everyone and therefore appear non-excludable but it is possible to exclude some consumers by reducing right to access or charging for entry.