What Market Failure Is — Market Failure & Externalities | IGCSE Economics

Exam Frequency Analysis

Past paper frequency (2018 to 2024)

This topic accounts for approximately 11% of your exam marks.

increasing

Medium

Increasing11%

Externalities and market failure corrective policies are increasingly tested; particularly in evaluate questions since 2020.

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 causes of market failure:

(negative externalities — over-production of harmful goods).
External benefits (positive externalities — under-production of beneficial goods).
(non-provision because of the free-rider problem).
Merit and (information failures cause mis-consumption).
Abuse of power (a single firm restricts supply and raises price).

Sections 2–8 below cover each one and the policies the government can use to correct it.

Exam tip

Defining and analysing market failure

What comes up: "Define market failure" [2] or "Analyse the consequences of market failure" [6].

Write (two marks): (1) The free market fails to allocate resources efficiently (2) from society's point of view — the price mechanism over-produces goods with external costs and under-produces goods with external benefits.

Write (six marks): Build a chain for each type: overconsumption of demerit goods and goods with external costs leads to misallocation of resources; underconsumption of merit goods and goods with external benefits means society gets too little of beneficial output; public goods go unprovided entirely due to the free-rider problem.

Watch out: A common dropped mark is saying the market "fails to produce goods" — the credit requires "fails to allocate resources efficiently", not simply "fails to produce". Efficiency from society's standpoint is the key phrase.