Markets over-produce goods with external costs, under-produce goods with external benefits, and fail to provide public goods.
Goods with external costs, and demerit goods, are over-consumed. Buyers and sellers ignore the harm to third parties, or underestimate the harm to themselves. More is produced than is best for society.
Goods with external benefits, and merit goods, are under-consumed. People ignore benefits to others, or underestimate benefits to themselves. Too little is produced and consumed.
Public goods are not provided by the market at all. Because no one can be excluded, people can use them without paying. This is the free rider problem, so firms cannot earn revenue.
Monopoly power is also a cause. A monopoly can restrict supply to push up the price, so consumers pay more and buy less than in a competitive market.
- Over-consumption
- Demerit goods and goods with external costs.
- Under-consumption
- Merit goods and goods with external benefits.
- Free rider problem
- People use a public good without paying, so firms will not supply it.
- Monopoly
- Restricts supply, causing higher prices.
Worked example: Writing a market failure chain
Explain why the market over-produces cars in a busy city.
- Identify the external cost: traffic jams and pollution harm other road users and residents.
- Explain why it is ignored: drivers consider only their own fuel and car costs.
- Consequence: more cars are bought and driven than is best for society, so resources are misallocated.
- Link: this is why governments use measures such as road pricing.
Watch out for this
Market failure means the market has collapsed and nothing is sold.
Market failure means the wrong amount is produced: too much, too little or none of a particular good. Most markets with failure still trade.
Check your understanding
Why does the free market fail to provide national defence?
- People cannot be excluded from its benefits, so they would not pay for it.
- It has external costs, so it is over-produced.
- Demand for defence is price elastic.