Market Failure & Externalities

Market failure occurs when the free market (operating through the price mechanism on its own) fails to allocate scarce resources efficiently from society's standpoint. Either too much or too little of a good is produced compared with what would be best for society as a whole.

The price mechanism (topic 6) usually does a good job of allocating resources. But it focuses only on the private costs and benefits seen by buyers and sellers; it ignores any cost or benefit that spills over onto other people. Where those spillovers are large, the resulting allocation is socially inefficient. That is market failure.

The five causes of market failure on the IGCSE syllabus:

1. Negative externalities (over-production of harmful goods).
2. Positive externalities (under-production of beneficial goods).
3. Public goods (under-provision because of the free-rider problem).
4. Merit and demerit goods (information failures cause mis-consumption).
5. Abuse of monopoly power and factor immobility (covered later in topics 10–11).

Sections 2–7 below cover each one and the policies the government can use to correct it.