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OCR AS Economics Module 1 Revision Notes –

Market Failure and Government Intervention

What is meant by Market Failure?

• Where markets work efficiently, the market mechanism produces the best
allocation of resources

• In reality, this doesn’t always happen, and in this case, market failure

• It is therefore said that markets ‘fail’

Efficiency Revisited and the Concept of Inefficiency

• Allocative efficiency is one type of efficiency

• The other is productive efficiency

• Productive efficiency can be explained in terms of production possibility


• To re-iterate, any combination of production that is located on the PPE is

one in which all available resources are being used efficiently

• Any point within the PPC represents inefficient use of resources

• Therefore, only when Allocative and productive efficiency are present can
we conclude that scarce resources are being used in the most efficient
way, from a consumer’s standpoint

• This is economic efficiency

• Inefficiency is therefore when resources are not being used in the best
possible way

• The products that people want aren’t being produced in the quantity that
they desire at the prices that they are willing to pay

Information Failure

• The aforementioned definition of economic efficiency is fine in theory

• However, for it to work in practise, consumers would need to have
accurate, up-to-date information on the quality and prices of products that
they want to consume

• It is a lack of this information that underpins most instances of market


• Increasingly, through things like the internet, we are provided with a mass
of information about the products we want to buy.

• Also, better labelling on products such as good and drink help base our
purchasing decisions

• Other products like tobacco and alcoholic drinks may contain information
to limit or stop the consumption of a product

• In principle, the wealth of information should enable us to make rational

decisions that are needed to maximise our own welfare and that of society

• If this is happening, then the market is working efficiently

• If it is not, then there will be an inefficient allocation of resources, and

hence, market failure

• The problem of information failure is that decisions taken by consumers

are based on ignorance, often due to inaccurate or incomplete information

o For example, where consumers are not aware of the benefits or

harmful effects of consuming a particular product

o Where persuasive advertising results in consumption levels that are

not in the best interests of consumers

o Where product packaging makes claims that are inaccurate or


• In some situations, the problem of information failure is known as

asymmetric information.

• Examples include things like:

o Health Care – when you visit your doctor, you don’t have the same
medical knowledge as them. You therefore rely on the doctor’s
experience and knowledge to give you the treatment you need.
o Environment – As individuals, we know very little about the
environmental consequences of driving cars or tipping waste.
Environmental experts are more aware of these effects due to their
own research.

o Consumer Purchases – What we originally think to be a good deal

may not be so. Mobile phone contracts may be a nightmare to
understand. The seller, who is on commission, has far more
knowledge on such matters than the consumer, and as such, the
consumer may make a bad choice due to the biased information of
the seller.

• In these examples, the lack of accurate information has distorted how the
market allocates resources

• In other words, the market has failed


• See definition and ‘examples’

Costs and Benefits

• Economists are interested in externalities because of the various costs and

benefits that arise out of the actions of others

• There are 3 types of costs and benefits:

• Private Costs and Private Benefits

o There are experienced by the people who are directly involved in

the decision to take a particular action

• External Costs and External Benefits

o These are a consequence of externalities that arise from a

particular action

o They fall on third parties instead of those responsible for the action

• Social Costs and Social Benefits

o These are the total costs and benefits to society as a result of a

particular action

o By definition, they consist of private costs and benefits and any

external costs and benefits that arise

• A problem therefore arises when the private costs or benefits do not equal
the social costs or benefits
• The external costs or benefit distort the efficiency allocation of resources

• It is for this reason that the market fails to produce the best allocation of

Negative Externalities

• There are several cases where negative externalities may exist

• This means that there are costs imposed on a third party over and
above the costs directly paid for by those who carry out the activity

• See example table

• At price P and quantity Q, the curve only take
into account the private costs of an action


• When external costs are taken into account, the

supply curve shifts to the left - from S to S1
• The result is an increase in price and a fall in
P equilibrium quantity to Q1

• The problem with negative externalities is

therefore over-production of Q-Q1, and the price
Q1 Q
paid is lower than it should be

• Too many scarce resources are being used.

Positive Externalities

• Examples of positive externalities are not as obvious or common as

instances of negative externalities

• As a consequence of positive externalities, the benefits received by a third

part are over and above those that are received by the people who carried
out the activity.

• At price P and quantity sold Q, external benefits

aren’t taken into account
• If they were, the demand curve would shift to the
P right, resulting in the market equilibrium being at
P1 and Q1.
• Where the market fails to work this way, there is
D under-production
Q Q1
y • This is shown by the difference between Q1 and
Merit Goods and Demerit Goods

• Market can fail in the provision of merit goods and demerit goods

• Merit goods tend to have positive externalities associated with their

consumption, while demerit goods can have negative externalities

• See examples table

• The problem when categorizing merit and demerit goods is that value
judgements have to be made – it’s a subjective process

• Such judgements have to be made by someone – usually the government

• The assumption is that such decision-making institutions know better than

individuals what is good or bad for them

• With this approach, it is genuinely believe that individuals lack accurate

information about the positive or negative externalities

• There is obviously information failure here.

• Some economists think there’s no such thing as a merit/demerit good.

• They think that it is the individual and not the government that knows
what’s best for them

• This contradicts the view that the government knows better due to greater
information at their disposal

• Because consumers don’t have the information available to make a

decision on whether it’s a good thing to consume a product (with regards
to merit goods), merit goods will be under-consumed and under-produced
in a free market situation

• Resources aren’t efficiently allocated, so the market’s failing.

• Once again, value judgements are involved for demerit goods

• See Example Table

Public Goods

• Public goods are consumed collectively

• It is difficult to charge for them directly, so they’re often financed via taxes

• If left to the free market, most public goods wouldn’t be provided

• Non excludability means that the good is provided for all irrespective of
whether they have paid for the product indirectly through taxation

• People that use public goods but haven’t paid for its provision are called
free riders

• Non-rivalry is also an important characteristic of public goods

• The aforementioned characteristics (non rivalry and non excludability) are

ideals of a pure public good – which makes them the opposite of private

• In the real world, not all public goods possess both characteristics to the
same extent

• Most quasi-public goods tend to be non excludable, but isn’t non-rval

• They therefore have some of the qualities of a private good

• See example table

Government Intervention to Correct Market Failure

• Governments intervene in the workings of the market mechanism to

correct market failures

• Some ways are obvious, others are less so

• Governments use a variety of methods to correct market failure

• The extent and intensity of such methods depends on how

concerned the government is about a particular market failure, and
whether the government intervention will produce a better
allocation of resources.

• There are two types of method that the government can take:

o Methods that involve manipulation of the market mechanism

(subsidies, indirect taxation)
 These are generally referred to as marked based

o Non market methods

 Direct forms of provision and various forms of regulation

and control


• There’s a wide range of taxes implemented by central and local

governments on firms and consumers in the UK

• Here are two main kinds of tax:

o Direct taxes, such as income tax and corporation tax

o Indirect taxes, such as VAT and excise duties

• The burden of tax is roughly evenly split between direct and indirect

• All forms of taxation are paid to the government, which in turn

allocates tax revenue to various forms of public spending

• There is very little hypothecation

• As previously mentioned, a lot of tax revenue is needed to finance

merit goods and public goods

• Indirect taxes are widely used to discourage the production of

demerit goods and goods that produce negative externalities

• Although this tax is imposed on the producer, most forms of indirect

tax tends to be passed on to consumers

• This obviously leads to an increase in


• The graph shows the outcome when a new tax, t,
S is imposed on this type of product.

P1 • The new tax leads to a shift to the left of the

supply curve (S to S1)
P t

• This means that less will be demanded and
D supplied as the market price has increased
Q1 Q
y • The area A represents the consumers’ share of
the tax burden
• In principle, the tax that’s imposed should equal; the value of the negative

• When this occurs, the producer is required to pay the tax in full

• Prices charged therefore take into account the cost of the negative

• In this way, the external cost is internalised to the producer

• A tax such as this is consistent with the ‘producer pays principle’

• This is fine in theory, but difficult to apply in practise for four reasons:

o There are problems determining the exact amount of the tax, as it’s
difficult to estimate the monetary cost of a negative externality

o Producers may not always pay the full amount of the tax, and it’s
often shared with the consumer

o PED for many demerit goods is inelastic, meaning that consumption

may not be reduced as much as intended, with the result that
production is higher than intended

o Better quality information for consumers might also be used to

further reduce consumption


• The purpose of a subsidy is to reduce the cost in order to provide a higher

level of production or consumption than would exist if it was left to the
free market

• Such payments are particularly relevant in the case of merit goods and
where products generate positive externalities

• In all such cases, if left to the free market, there would be under-
production and under-consumption.

• In some respects, the subsidy’s the opposite of
an indirect tax

P1 • The graph shows the effect on market

equilibrium following the payment of a subsidy
• Introducing a subsidy leads to a shift to the right
in the supply curve (S to S1)
Q Q1
• Allocating subsidies can be controversial.

• An important thing to consider when deciding to allocate a subsidy is

whether there is an external benefit

Regulations, Standards and Legal Controls

• The government use other methods to correct market failure that doesn’t
involve the direct use of the price mechanism

• These take the form of regulations, standards and legal controls

• All such controls are used by the government to combat market failure

• If it was left to the free market, undesirable outcomes would occur

• The purpose of such controls is to override the workings of the market


• Action by the government on someone breaking the legislature can range

from a written warning, to a fine, to a closure of a business

• In theory, the standards set should achieve what the legislation see as an
optimum scale of activity or use

• If, for example, standards are too low, the polluter receives benefits that
are greater than the external costs of the pollution caused

• If standards are too severe, the polluter might be tempted to emit

pollutants into the air or water, particularly if risk of detection is low.

• To set standards, one needs accurate information, which is often hard to


• For example, it is difficult to identify the source of some pollution

• Once standards have been set, there is no incentive to work in a more

environmentally friendly way

• Nevertheless, regulations and standards are a very important way of

reducing many forms of environmental pollution that would otherwise
have been unavoidable.
Tradable Permits

• Tradable permits are a market-based means of correcting market failure

• The total number of permits is strictly controlled as a means of limiting the

overall level of pollution

• The permits can be bought and sold at an agreed price between the owner
and purchaser

• The incentive is for permit holders to achieve a lower level of pollution, so

they can sell the permit on.

• Tradable permits therefore combine the benefits of a market solution with

those of regulation

• If firms don’t have sufficient permits to cover their pollution, they will be
Price of permits

• The graph shows how the price of permits is
determined in theory

• The supply of permits is fixed (Q)


• When the demand for permits is D, price is P

• If more polluters require permits, D will shift
outwards to D1, increasing the price to P1
Q Quantit

• There are some problems to permits

o There’s a problem calculating and distributing the permits to


o It’s hard to calculate the market price for traded permits

o Enforcing and policing the system is difficult and costly

Role of Government in Information Provision

• Seeing as information failure is one of the causes of market failure, it

seems logical to expect governments to provide information in order to
correct market failure

• This is mainly with respect to the provision of demerit goods

• Governments have been keen to provide information on social costs as
well as private costs involved in a product’s consumption

• In most cases, such information has been accompanied by regulations and


• The government also ensures, through the Advertising Standards Agency,

that the advertisers are truthful about the claims made about their
products – particularly health and beauty

• Via this, it is hoped that consumers will receive truthful and impartial