Market failure happens when the price mechanism allocates resources inefficiently, producing too much or too little.
Market failure is when the market, left alone, fails to allocate resources efficiently. It produces too much of some goods, too little of others, or none at all.
Private costs and benefits are those that fall on the people buying or selling. External costs and benefits fall on third parties: people outside the transaction. Social cost = private cost + external cost. Social benefit = private benefit + external benefit.
A merit good, such as education or vaccination, is more beneficial than people realise and gives external benefits. A demerit good, such as cigarettes, is more harmful than people realise and gives external costs.
A public good, such as street lighting or national defence, is non-rival and non-excludable. One person using it does not reduce what others get, and nobody can be stopped from using it. A monopoly is a single seller of a product.
- Market failure
- Inefficient allocation of resources by the market.
- Social cost
- Private cost + external cost.
- Social benefit
- Private benefit + external benefit.
- Public good
- Non-rival and non-excludable, such as street lighting.
Worked example: Separating private, external and social costs
A factory produces paint and releases fumes into the air.
- Private costs: what the factory pays for paint ingredients, wages and electricity.
- External costs: nearby residents suffer breathing problems and must clean their homes more often. They did not agree to this and are not paid for it.
- Social cost: private costs plus external costs. This is the full cost to society of making the paint.
Watch out for this
External costs are the extra costs a firm pays for pollution control.
External costs fall on third parties, not on the buyer or seller. If the firm pays, it is a private cost.
Check your understanding
Why is street lighting a public good?
- It is non-rival and non-excludable: one person's use does not reduce another's, and no one can be kept out.
- It is provided by the government.
- It is more beneficial than people realise.