Study Notes
Overview
Market Failure is a cornerstone of the OCR J205 specification. It addresses the critical question of why free markets, often hailed for their efficiency, sometimes fail to allocate resources in a way that maximises society's welfare. For examiners, this isn't just about identifying problems; it's about a candidate's ability to analyse the mechanism of failure and evaluate the government's response. This guide will equip you with the precise language, analytical frameworks, and evaluative skills needed to deconstruct any market failure question. We will explore the core concepts of externalities, public goods, and information asymmetry, providing you with the tools to explain not just what they are, but how they lead to a misallocation of resources and why government intervention becomes necessary.
Key Concepts
1. Externalities
An externality is a cost or a benefit that affects a third party who is not directly involved in an economic transaction. The market only accounts for the private costs and benefits of the producers and consumers, ignoring these spill-over effects on others. This leads to a divergence between private and social costs/benefits.
**Negative Externalities (External Costs)**These are harmful effects on third parties. The social cost (the full cost to society) is greater than the private cost (the cost to the producer). Because producers do not pay the external cost, they overproduce the good, leading to a misallocation of resources and a welfare loss.
- Example: A factory polluting a river. The private cost is the cost of production (labour, materials). The external cost is the harm to the environment and local residents' health. Social Cost = Private Cost + External Cost.
**Positive Externalities (External Benefits)**These are beneficial effects on third parties. The social benefit (the full benefit to society) is greater than the private benefit (the benefit to the consumer). Because consumers do not receive the full social benefit, they under-consume the good, leading to a misallocation of resources.
- Example: An individual getting vaccinated. The private benefit is their own immunity. The external benefit is that others in the community are less likely to get ill (herd immunity). Social Benefit = Private Benefit + External Benefit.
2. Public Goods
Public goods are a specific type of market failure where the market fails to provide them at all (a missing market). To gain full marks, candidates MUST define them using two key characteristics:
- Non-Excludable: Once the good is provided, it is impossible to stop non-paying individuals from benefiting from it.
- Non-Rival: One person's consumption of the good does not reduce the amount available for others.
This creates the free-rider problem: individuals have no incentive to pay for the good, as they can benefit without contributing. Private firms will not supply public goods because they cannot make a profit. Therefore, the government must provide them directly.
- Examples: National defence, street lighting, lighthouses.
3. Information Asymmetry
This occurs when one party in a transaction has more information than the other. This imbalance can lead to poor decision-making and cause the market to fail.
- Example: The market for second-hand cars. The seller knows the car's full history (is it a reliable 'peach' or a faulty 'lemon'?), but the buyer does not. The buyer, fearing they will buy a lemon, is only willing to pay an average price. This low price drives sellers of good cars out of the market, leaving only lemons for sale. The market shrinks and may collapse entirely.
Government Intervention
To correct market failure, governments can use a range of policies:
- Indirect Taxes: Increase the price of goods with negative externalities (demerit goods) to reduce consumption. The tax internalises the external cost.
- Subsidies: Decrease the price of goods with positive externalities (merit goods) to encourage consumption.
- Regulation: Rules and laws to control behaviour (e.g., banning smoking in public places, setting pollution limits).
- State Provision: The government provides public goods directly, funded through taxation.
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