Types of market failure

A) Understanding of market failure

Market failure occurs when the free market fails to allocate resources at the socially optimum level, leading to inefficient outcomes and therefore a net welfare loss to society.  


B) Types of market failure


Negative externalities are costs that occur to third parties as a result of economic transactions between either consumers or producers. The two types of negative externalities include overconsumption and overproduction. The main reason externalities occur is due to consumers and producers self-interest. Rational consumers make decisions based on the private costs and benefits to themselves and do not consider any external costs/benefits caused by their consumption of a good/service. This can be shown by the excessive consumption of sugary drinks in the UK.



Rational consumers consume sugary drinks up to the point where the private marginal benefit of consuming a sugary drink is equal to private marginal cost. However, they do not consider the impact this consumption may have on society as a whole. For example, excessive consumption of sugary drinks can lead to health problems; this will mean that the consumer will have to visit the doctor more times than if they didn’t consume excessive amounts of sugar. This will cost the taxpayer more money and will take up more of NHS’s doctors’ time when they could have been dealing with other patients. Therefore, that consumer’s decision to drink a large amount of sugary drinks has affected third parties negatively.  Instead of consuming up to the point where the marginal social cost is equal to the marginal social benefit (the social optimum point), they have consumed up to the point where the marginal private benefit is equal to the marginal private cost (private optimum level). At the quantity of units from the private optimum point to the social optimum point, the marginal social costs have been higher than the marginal social benefits, meaning that a welfare loss has occurred. Any time the market operates at a point where the marginal social costs don’t equal the marginal social benefits, the market has failed. This will be explained in further detail with the use of a diagram in the next topic (1.3.2 externalities).



Any factory that produces excessive pollution can be used as an example of overproduction e.g. car factories. This is because; the overproduction of cars can cause large amounts of pollution which then has negative third party effects on the environment as a whole. Furthermore, third parties that weren’t involved in the car production such as people suffering from asthma can also be harmed. This is because the inhalation of excessive amounts of pollution can cause their breathing problems to get worse. However, due to producers acting in their own self-interest they won’t take this into consideration when making economic decision. Therefore they will continue to overproduce cars as long as there is no government intervention in the market to prevent this. Therefore the market will not be operating at the socially optimum point causing market failure.


Positive externalities are benefits that occur to third parties as a result of separate economics transactions between consumers or producers. The two types of positive externalities include underproduction and under consumption.


(Under consumption):

An example of a good/service that is under consumed is fruit. The consumption of fruit has been proven to reduce the risk of health issues such as heart disease. Therefore a person that eats the recommended intake of fruit is less likely to visit the doctor as often as much as someone who doesn’t thus saving the NHS money as well as giving doctors more time to treat other patients. Therefore, third party agents that weren’t involved in the initial economic transaction (the consumption of fruit) will benefit. However, as consumers act in their own self-interest they will not take into account these third party benefits. As a result of this, they will only consume up to the private optimum level rather than the social optimum level. This causes fruit to be under consumed resulting in third parties missing out on the benefits that they could receive if fruit was consumed up to the socially optimum level. As a result of this, society will experience a social welfare loss caused by the under consumption of fruit.



One example of underproduction is green technology such as solar panels. The production of solar panels reduces the amount of non-renewable sources of energy being used such as coal. These types of energy are often harmful to the environment due to the fossil fuels they emit.  Therefore, the production of solar panels is environmentally friendly which benefits third parties such as those that live in busy town centres that may suffer health issues as a result of the excessive inhalation of pollution. However, as producers act in their own self-interest, they will only produce up to the private optimum point rather than the socially optimum point. Therefore units from the private optimum point up to the socially optimum point will not be produced despite the marginal social benefits being greater than the marginal social costs. This means that society will miss out on the benefits that would be gained if those units were produced. Therefore a social welfare loss will occur.


Under-provision of public goods

Public goods are goods/services that are often provided by the government with an intention to fill a missing market that private firms will not operate in. Public goods are often non-profit making e.g. a lighthouse. The main two characteristics of a public good are:
Non rival:

This means that the consumption of a good/service by another individual does not reduce the amount of benefit derived from that good/service to other people. For example a person that is standing by a streetlight does not lose benefit from that street light if another person stands in the light also.


Non excludable:

The benefit derived from the good/service is unable to be excluded from certain individuals. For example, a person that does not pay taxes will still benefit from the armed services who protect their country. The armed services cannot refuse to protect certain individuals who do not pay their taxes.

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