Market failure and government intervention
Market failure occurs when the free market mechanism, left alone, fails to allocate resources efficiently, meaning total welfare, the sum of consumer and producer surplus, is not maximised, or resources are misallocated relative to what would benefit society as a whole.
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Method
- Define market failure precisely as a situation where the free market fails to achieve an efficient allocation of resources, i.e. total, community, welfare is not maximised, distinguishing it from a market outcome someone simply dislikes.
- List the main causes of market failure covered at A Level: externalities, negative or positive, in production or consumption, public goods and the free-rider problem, information gaps or asymmetric information, and market power or monopoly.
- Define a negative externality, a cost imposed on a third party not involved in the transaction, e.g. pollution, and a positive externality, a benefit received by a third party, e.g. from vaccination or education, and explain that in both cases the free market will not produce the socially optimal quantity.
- Define a public good using its two technical properties: non-excludable, once provided no one can be stopped from consuming it, e.g. street lighting, and non-rival, one person's consumption does not reduce what is available to anyone else, and explain how this causes the free-rider problem.
- Define asymmetric information, where one party in a transaction has more or better information than the other, e.g. a used car seller knowing more about a car's faults than the buyer, and explain how it can lead to a worse-than-optimal quantity or quality of trade.
- List the range of government interventions available and match each to the market failure it targets: indirect taxes and tradable permits for negative externalities, subsidies and direct provision for positive externalities or public goods, regulation for a variety of failures, and information provision for information gaps.
- Define government failure as a situation where government intervention, intended to correct a market failure, itself leads to a misallocation of resources or a net loss of economic welfare, and use it as the standard evaluation point when assessing any single policy.
Worked example
A factory's private marginal cost of producing one more unit is 15 pounds. Producing that unit also imposes 6 pounds of pollution costs on nearby residents, who are not compensated. Calculate the social marginal cost of that unit of output, and explain why the free market, using only private cost, would lead to overproduction relative to the socially optimal level.
- Identify the private marginal cost: 15 pounds, the cost to the factory itself of producing the unit.
- Identify the external cost: 6 pounds, the uncompensated cost imposed on nearby residents from pollution.
- Calculate the social marginal cost: social marginal cost = private marginal cost + external cost = 15 + 6 = 21 pounds.
- Explain the market failure: a profit-maximising firm sets output based only on its own private marginal cost (15 pounds) compared with the price/marginal revenue it receives, ignoring the extra 6 pounds of external cost borne by residents.
- Conclude: because the firm does not take the full 21 pounds social marginal cost into account, it will keep producing units for which price exceeds private marginal cost but is below social marginal cost, so it produces more output than the socially optimal level, where price should equal social marginal cost.
Practice questions
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Q1Define market failure.Show answer
Answer: A situation where the free market fails to allocate resources efficiently, so total, community, economic welfare is not maximised.
Q2Define a negative externality.Show answer
Answer: A cost of an economic transaction that falls on a third party not directly involved in that transaction, e.g. air pollution affecting nearby residents.
Q3State the two technical properties of a pure public good.Show answer
Answer: Non-excludable, no one can be prevented from consuming it once it is provided, and non-rival, one person's consumption does not reduce what is available for others.
Q4What is the 'free-rider problem'?Show answer
Answer: The problem that, because a public good is non-excludable, people can benefit from it without paying, giving private firms no incentive to supply it and potentially causing under-provision without government action.
Q5Define asymmetric information, with an example.Show answer
Answer: A situation where one party to a transaction has more or better information than the other, e.g. a used car seller knowing more about hidden faults in the car than a buyer does.
Q6Name one government policy used to correct a negative externality and one used to correct a positive externality.Show answer
Answer: For example, an indirect tax or tradable pollution permits to correct a negative externality, and a subsidy or direct government provision to correct a positive externality.
Q7Give one reason a government intervention intended to correct market failure can leave society worse off.Show answer
Answer: Information gaps mean the intervention can be set at the wrong level, for example a tax larger than the external cost, which over-corrects and creates a new welfare loss. Administrative costs and unintended consequences such as black markets can outweigh the gain.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Using a diagram, explain how a negative production externality leads to a welfare loss in a free market.
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Evaluate the effectiveness of government intervention in correcting market failure caused by negative externalities.
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See real A Level Economics past-paper questions, with official mark schemes →
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