A) Understanding market failure

In a free market, consumers and producers generally make decisions based on their own private costs and benefits.

However, these decisions do not always result in the level of production or consumption which is best for society as a whole. When the market does not operate at the socially optimum level, market failure occurs.

B) Externalities

Externalities are costs or benefits which affect third parties who are not directly involved in the original economic transaction.

Negative externalities

Negative externalities occur when an economic activity creates costs for third parties. They can result in overconsumption or overproduction.

For example, excessive consumption of sugary drinks may create additional costs for the health service, while pollution created during production can impose costs on people who were not involved in producing or buying the product.

Positive externalities

Positive externalities occur when an economic activity creates benefits for third parties. They can result in underconsumption or underproduction.

For example, the consumption of goods which improve health may provide benefits to society beyond those received by the individual consumer.

C) Under-provision of public goods

Public goods may be underprovided by the free market because private firms can find it difficult to charge consumers for the benefits they receive.

Public goods have two important characteristics:

• Non-rival – one person’s consumption of the good does not reduce the benefit available to somebody else.
• Non-excludable – it is difficult or impossible to prevent somebody from receiving the benefit of the good.

These characteristics can make it difficult for private firms to provide public goods profitably, which can result in a missing market.

D) Information gaps

An information gap exists where consumers or producers do not have all of the information needed to make an economic decision, or where the information available to them is inaccurate or misleading.

This can cause too much or too little of a good or service to be consumed or produced, resulting in a misallocation of resources.

What the full guide adds

For this topic, the full AS guide also covers:

• A fuller explanation of private and socially optimum levels of consumption and production and how the difference between them creates a welfare loss.
• Detailed examples of overconsumption and overproduction, including sugary drinks and pollution.
• Detailed examples of underconsumption and underproduction, including health-related consumption and green technology.
• The free-rider problem and why the non-rival and non-excludable nature of public goods can lead to under-provision.
• Worked examples of information gaps, including merit and demerit goods such as education and cigarettes.