Market Failure and Externalities

Understanding Market Failure

Market failure refers to a situation where the free market does not allocate resources efficiently, resulting in a loss of economic and social welfare.
This could occur due to imperfect information, externalities, inequality, or the non-existence of markets for certain goods or services.
Public goods, quasi-public goods, and merit goods are three types of goods that often lead to market failure due to their unique characteristics leading to issues in market provision.

Externalities and Their Impact

Externalities are third-party effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid.
Externalities can be positive, where the social benefits exceeds the private benefits, or negative, where the social cost exceeds the private cost.
Examples of negative externalities include pollution and noise, while examples of positive externalities are education or health services leading to a more informed or healthier population.
Externalities can lead to market failure if people’s decisions do not align with the best interests of society overall.

Internalising Externalities

Internalising externalities occurs when the social costs or benefits of an action are taken into account by those directly engaged in production or consumption.
This could be achieved through a variety of strategies such as taxes, regulation, government provision, or property rights being well-defined and enforced.
These strategies aim to correct the market outcome to the socially efficient outcome, where social cost equals social benefit.

Public Goods and Market Failure

Public goods are non-excludable and non-rivalrous, meaning one person’s use doesn’t diminish another’s and it’s not possible to prevent non-payers from getting the benefit.
As a result, public goods are likely to be under-provided in a free market setting, leading to market failure.
An example of a public good would be national defence or streetlighting.

Merit and Demerit Goods

Merit goods are goods that are socially desirable but are likely to be under-consumed and under-produced in a free market, such as education or vaccination.
Demerit goods are socially undesirable goods that are over-consumed and over-provided in a free market, like cigarettes or alcohol.
These goods provide a case for government intervention to correct the market failure.